May 3rd 2008 - Financial Times
By Vitaliy Katsenelson, CFA
I love the price/earnings ratio, but like all investment tools, it is flawed. This is because it is only as good as the numbers that go into it. There is no debate about the “p” in the equation – price is quoted every second. But the “e”, though readily available, is only as good as the best estimates.
Many people describe the stock market as cheap. After all, at 18 times earnings, p/es are half of what they were eight years ago (those bubbly valuations are not coming back anytime soon) and only three points above their long-term average of 15. However, the “e” is temporarily inflated by all-time high (pre-tax) profit margins, which are at 11.5 per cent, or about 35 per cent higher than their multi-decade average of 8.5 per cent.
Historically, every time profit margins have become overextended, they have reverted towards the mean (that is, declined). This is because capitalism works. One company’s excess profits are another’s potential opportunity – increased competition puts pressure on profit margins. This time round is no different. If profit margins fell and stopped when they reached the average level – an aggressive assumption as historically they have overshot and gone lower – the market’s p/e would rise from 18 to 22.
The same logic applies to individual stocks. Most excess profit today is generated from three sectors: “stuff” (energy, materials and industrials); financials; and the “new” economy (telecommunications and technology). “Stuff” stocks are responsible for about half of the overall excesses in profits. Historically their sales and profits have moved in tandem with the US economy. However, as fast-growing, “stuff hungry” nations such as India and China became a larger part of the global economy, these stocks started moving less with their domestic economies and more with the global economy. A slowdown in the US alone may not be enough to derail their high profit margins, though it may trigger a gradual process of global slowdown. The global economy has to slow down before the margins of “stuff” stocks will decline.
These companies have a high proportion of fixed costs, meaning that their margins increase in good times (a concept known as operational leverage). But that leverage could now work in the opposite direction – lower sales and high fixed costs will push margins to the other extreme. Earnings will either decline or stop rising and cheap stocks won’t be cheap any longer. Timing the global economic cycle is impossible as it is driven by random variables. While it may appear that India and China operate by a different economic playbook, they do not. When growth, especially fast growth, takes place in countries where rule of law and free market practices are still developing, it breeds inefficiencies. Recession exposes underlying problems. The risk is China and India will slow down, fall into recession, and consume less “stuff”.
[Since recession may bring a political unrest in China and India, their respective governments will likely fight it using every bullet in the monetary and fiscal arsenal, but recession can be postponed but cannot be escaped. ] The second group, financial companies, are responsible for about 20 per cent of excess profits. Cheap money and loose lending practises fuelled the excesses, but rising loan defaults mean that margins are now compressing.
The last group, the “new” economy stocks are responsible for slightly less than 20 per cent of overall margin excesses. The technology and telecoms sectors have changed dramatically over the past two decades; higher-margin software and services now account for a much larger portion of sales. The “new” economy stocks should have higher margins than they had in the past, but by how much? I don’t know, but they likely will face a lower margin compression than “stuff” stocks and financials. We are in a “global cyclicality bubble” not unlike the bubble of the late 1990s or the housing bubble of the 2000s. Since cyclical companies have not seen the other, darker, side of the cycle for a while – many are granted historically high valuations on top of cyclically high earnings.
Don’t abandon the p/e ratio, but adjust the earnings for high margins. Take a close look at the profit margins of the stocks in your portfolio and ask yourself if today’s margins are sustainable. If you adjusted margins to the historical average, would the stock still look cheap? If you own a stock that belongs to the “stuff” or financial services groups, assume its high margins won’t last. The writer is director of research at Investment Management Associates and author of Active Value Investing.
May 10th, 2008
I’ll be attending Berkshire Hathaway’s annual meeting this weekend. I’ll do a book signing at the Omaha Dairy Queen from 8:30-10pm on Friday May 2nd (West Dodge Dairy Queen, 404 N. 114th St.). I am very excited about attending and speaking at the Value Investing Congress on Tuesday May 6-7 at Pasadena CA. If you happen to attend one of these events, stop by and say hi.
After I wrote a piece on Starbucks (SBUX) raising questions about its future success in international expansion and questioning the growth premium built into the stock, I got a lot of great emails that really made me think (the best kind!).
About the stock: I saw a lot of value managers that I respect loading up on it, even at $5 higher. As price keeps declining, the stock is definitely becoming more interesting, however, I have not done enough research to figure at what price it turns into a buy.
I still have many questions that need to be answered, but here is a little story that really tells you about the quality of SBUX’s brand: A couple of weeks ago I guest-co-hosted a radio show in Denver. I decided to bring a gift to my co-host. It was 9am on a sunny Saturday, and coffee seemed like the right choice (for a very modest gift), plus I had an excuse to get one for myself. I stopped by a Starbucks, one of three that I encountered on my two-mile journey to the radio station. The show went well and my co-host appreciated the gesture.
Here is the thing, though. According to consumer surveys, McDonald’s (MCD) has better coffee. But I would have looked silly if brought a McDonald’s coffee instead. Some may disagree about the taste, but Starbucks went into our dictionaries as quality coffee.
For example, it’s hard to go wrong giving a Starbucks gift card, but people may look at you funny if you give them a McDonald’s gift card.
I know the issues about Starbucks – the McDonald’s entrée, the copycats, recession sensitivity, too many locations, international expansion worries. I’d have to have a better grasp on them before I buy the stock, but one thing is definitely clear to me – SBUX has a unbelievably strong brand, at least in the U.S.
After looking over readers’ feedback, I came to the following conclusion about SBUX’s international expansion: so far SBUX has succeeded in places where coffee-drinking is not deeply ingrained into the culture. In fact, the less coffee is ingrained on country’s culture the, the higher the chances of SBUX’s success.
I was amazed how many SBUX stores I saw in London. The U.K. is not a traditional coffee drinking nation – tea is the national drink. Japan falls into the same category. However, SBUX will have to climb a steep mountain in a good part of Europe (including Austria, Italy, Turkey, etc.) where coffee drinking is deeply ingrained in the culture.
Ironically, it seems that SBUX’s international success will depend on converting non-drinkers into drinkers.
Continue Reading April 29th, 2008
I wrote a guest column for John Maudlin’s weekly newsletter. Here are links to PDF and John’s website. John wrote the following introduction to the article:
- Are we in a bull, a bear, or a cowardly lion market? As we will see, the answer can make a huge difference in your investment portfolio. This week I am at my Strategic Investment conference in La Jolla. About four times a year I take a break from writing the letter and bring in a guest writer. This week Thoughts from the Frontline will have the very distinguished analyst and author Vitaliy Katsenelson.
- In his recent book, Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007), he exhorted investors to fasten their seat belts and lower expectations for the next decade or so. He also provided a strategy for improving returns in this environment, what he calls range-bound or cowardly lion markets. Long-time readers will recognize some themes consistent with my own research, but Vitaliy adds some very interesting twists that I believe will make you think. In today’s letter, Vitaliy runs through his analysis of what will happen and provides an overview of how investors can make money in what will otherwise be an ocean of stagnant returns. Warning: the letter will print long, but that is because there are a lot of great charts.
- Let me also highly recommend Vitaliy’s book, Active Value Investing. I think as you read today’s letter, you will get a sense of why I am so enthusiastic about his work. You can get you copy at Amazon.com.
April 20th, 2008
I was interviewed by Active Trader Magazine (here is a link to PDF). What do I know about trading? Absolutely nothing! This is exactly what I told David Bukey, the editor of the magazine, when he asked me for an interview. He assured me that he read my book and thought my (investing) message was very important to his readers. How can you say no to that? David did a great job putting the interview together, though I’ll let you be the judge.
There is a small typo at the very end, the website I recommend (in addition to gurufocus.com) is Stockpickr.com NOT stockticker.com.
April 6th, 2008
I just came back from a week-long trip in Europe where I spent four days in Vienna and three days in Sofia (Bulgaria). I was surprised to find very few Starbucks (SBUX) shops in Vienna.
Despite traveling extensively around the city I counted only two. Both are primarily frequented by — you guessed it — tourists. I’ve been told SBUX has closed down a number of stores over the years. After visiting London in August and seeing a SBUX on every corner, I figured the firm had spread the decaying American capitalism evenly around the world. Remember, Britain is a nation that drinks tea - or so we’ve been told.
The only explanation I could find was that Austrians look at coffee as an experience. Since they pay a couple euros for a tiny little bitty cup of coffee, they figure they may as well enjoy it by spending an hour drinking it. In America we drink the same amount in a sip. Maybe Austrians want their coffee brought to them. Though I have to confess, service in Europe rivals service I receive in the local Post Office on the day before Christmas.
Continue Reading March 28th, 2008
DENVER (MarketWatch) — The certainty that we have to file a tax return every year, that the number of tax returns is rising, tax preparation is getting more complex and thus despite availability of tax preparation software more and more people outsource their tax preparation peaked my interest in Jackson Hewitt.
Well, of course, if flat-tax Ron Paul becomes president he’d pull a rug out from under the tax preparation industry. But let’s be real, a complex tax system is here to stay as it brings too many carrots and sticks which politicians will not part in a million years.
However, when Jackson Hewitt (JTX) reported its quarterly results in March the certainty was not certain anymore. Jackson Hewitt’s revenues were down 15%, street expectations were missed, and the stock took a dive. How could this happen?
Continue Reading March 11th, 2008
I find January to be one of the most difficult months for long-term investors. In the spirit of the fine American tradition of making New Year’s resolutions, we feel a need to make a resolution for the stock market (as if it will listen to us) in the form of a prediction.
I don’t dismiss the benefits of forecasting, but we should forecast what we can forecast – market timing is not it. We just listen to our gut (which for all I care could be influenced by the fat content of food consumed at the time of the prediction) and verbalize it in well structured sentences that give our fortune telling much needed sophistication.
Though some do a great job playing market timers on business TV, with the assistance of sound horns and theatrical Oscar-like performances, the advice granted is not worth the damage to your ears or eyes. Timing short-term markets is a loser’s game. Let’s be honest with ourselves - we really don’t know.
The problem with forecasting short-term market movements is that even if you get the economic event right and Lady Luck kisses you on the cheek and you nail its timing, the market may just spit in your direction and chose to ignore it till a later date. Last summer, for example, the housing bubble finally burst, bringing the toxic waste (sub-prime) loans onto the surface. Credit markets froze… and you’d think the stock market would decline? No, the Dow went on to make an all time high, hitting 14,000 and ignoring the problems for months.
Let’s leave the market timing to the media, take a drink of cold water and approach forecasting the right way. Even a long-term investor has to recognize that long-term consists of a series of short-terms. The tsunami of short-term events may change the direction of the long-term. We have to accept that we probably won’t get the timing right, adopt an “I’d rather be vaguely right than precisely wrong” attitude, focus on identifying shorter-term risks that may stand between us and the long-term, and stress test our portfolio for them accordingly.
It would be careless to dismiss the possibility of a recession (some argue that we already are in a recession). Past recessions were caused by excesses of inventory and overcapacity in the corporate sector. As corporations rationalized their inventories and factories, higher unemployment followed – we were in a recession. Excesses were worked out, corporations started to hire, and voila - we were out of the recession.
Continue Reading March 5th, 2008
This market requires patience and more patience. Identify high quality companies you want to own, determine at what price and wait. That is what I’ve been doing. Also, since profit margins are hitting all time high, the “E” in the P/E equation is very deceiving. Earnings in many cases have been tremendously overly stretched to the upside: They’ll need to be un-stretched (i.e. normalized).
For instance, if you look at Moody’s (MCO), the stock, it may appear cheap, about 15 times 2007 earnings. Not bad for a legal duopoly. But MCO’s earnings are up tremendously since 2004. I’d argue that earnings since 2004 were bubbled by the housing-derivatives-easy-credit bubble. Thus when valuing MCO I’d put little faith in 2007-2008 numbers and go back to more normal times with 2004 EPS of 1.50 (as opposed to $2.50 MCO earned in 2007).
I’d gladly pay 14-15 times earnings for this still incredible business, thus Moody’s will go on my “Stocks I’d Love to Own” list at $21-22. Yes, stock has to decline 40% for me to become interested. Am I too conservative? Will I miss buying a great company? Possibly, but there are plenty of other great companies where this one came from.
March 3rd, 2008
After I wrote the profit margin article for Barron’s couple of weeks ago, I received many inquiries asking me to identify which sectors were the least and the most impacted by rise of corporate profit margins. In the interview I gave to Advisor Perspectives (link to download PDF and link to website) I did just that.
February 20th, 2008
I was interviewed by Jim Puplava at FinancialSense.com. This is the most detailed audio interview (you can stream audio or download MP3) about the book I’ve given so far (about forty minutes long).
February 9th, 2008
The following article was published in February 4th, 2008 issue of Barron’s. It is revised, updated partial excerpt from my book Active Value Investing: Making Money in Range-Bound Markets.
By Vitaliy Katsenelson
STOCKS ARE ALLEGEDLY CHEAP NOW, at 17 times 2007 earnings. And they are cheap by historical standards. Only seven years ago, they were at price/earnings ratios double today’s; they are even cheaper if you compare their forward earnings yield of 6.7% to Treasuries’ yield of 4.25%. They are cheap, cheap, cheap! Or so we’ve been told.
Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.
Many disagree that the profit-margin reversion will take place. Here are the most common arguments against it, and some food for thought on why “common” doesn’t necessarily translate as “wise.”
Who said that margins have to revert to a mean; why can’t they just remain high?
Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.
What about the billions of dollars U.S. companies poured into technology — weren’t they supposed to make these operations more efficient and bring higher profit margins?
The billions of dollars did not go to waste; companies are more productive now than ever before. Efficiency gains stemming from productivity were a source of competitive advantage and higher margins when access to proprietary technology was a competitive advantage.
For example, Wal-Mart’s rise in the retail industry was achieved through a very efficient inventory-management and distribution system that passed cost savings to consumers and drove less-efficient competitors out of business. Today, however, that same — or even better — technology is available off-the-shelf to retailers like Dollar Tree or Family Dollar, whose outlets are about the same size as a couple of Wal-Mart bathrooms put together. Oracle or SAP will gladly sell state-of-the-art distribution/inventory software systems to any outfit able to spell its name correctly on a check. Increased productivity didn’t and won’t bring permanently higher margins to corporate America — the consumer is the primary beneficiary of lower prices. If profit margins didn’t respond as they do, Wal-Mart’s net margins would be 25% today, not 3.5%.
Over the past 70 years, growth in corporate earnings and gross domestic product haven’t differed significantly. On the other hand, there has been a permanent benefit from increased operating efficiency: It lets companies hold less inventory and adjust more quickly and precisely to changes in demand. This has led to less volatile GDP.
Shouldn’t average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy?
It is not as much of a change as we might think. In 1980, services represented about 48% of GDP. After 27 years and a lot of changes like outsourcing, services have increased to 58% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 70 basis points above their 27-year average — between 8.9% and 9.2%, but still far below today’s 11.9% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 30% above their long-term mean.
Shouldn’t globalization allow U.S. companies to increase margins?
A larger portion of U.S. companies’ profits is coming from overseas than ever before. However, globalization is a double-edged sword — U.S. companies are expanding and will continue to expand overseas and capitalize on new opportunities. But as the world flattens, they also face new competition at home and abroad. For example, Motorola-a company that used to represent American might in the telecommunications arena — has been marginalized in the U.S. and around the world by companies whose names we didn’t recognize 15 years ago — Finland’s Nokia and South Korea’s Samsung.
Although Wal-Mart is rapidly expanding overseas, it will soon face a new breed of competition. U.K. retail giant Tesco recently entered the American market. U.S. companies may get a larger portion of their earnings from overseas (the weak dollar will only help), but they’ll have to fight to defend home turf.
International expansion doesn’t guarantee fatter margins, quite the opposite: We are about to face competition from countries that may be more concerned with increasing market share, even at the expense of short-term profitability.
High oil prices are here to stay, so maybe multiyear high margins in the energy sector are here to stay as well.
This would be the case if energy companies sold their products to customers in another galaxy where somebody else bore all the costs of high-energy prices. Petroleum products are consumed by corporations and individuals. The profit margins benefiting the energy sector are achieved at the expense of lower margins for companies that consume their products-which really is the rest of the corporate world, in various degrees.
Today’s stock valuation is a lot higher than it appears if you normalize earnings to lower profit margins. And while it’s hard to tell when earnings will embark on a fateful journey to seek their historic mean, it should happen sooner than later. Earnings will either decline or grow at a slower pace than GDP.
Depending on the industry structure, companies that don’t have a sustainable competitive advantage will not be able to keep competition at bay, and will face margin compression, along with lower earnings growth or declining earnings. Look at your portfolio: Can the companies whose margins are hitting all-time highs sustain them?
VITALIY N. KATSENELSON is a portfolio manager at Investment Management Associates in Denver, and the author of Active Value Investing: Making Money in Range-Bound Markets (Wiley, 2007)
P.S. The following two charts really tell a great story about profit margin compression overtime. Due to readers request I created one based on GDP and one based on GNP. As you can see there is little difference between them as GDP (domestic product) and GNP (national product) are very similar. An additional point: margins don’t have to revert and stop at the mean, historically they went below the mean (that is how mean is created).
February 4th, 2008
Hank Greenberg, the ex-chairman of AIG (AIG), the guy who made AIG what it is today, hired an investment banker to help him figure out what the company is worth.
He is thinking about unloading the stock. If Hank doesn’t want to own this financial conglomerate - and he knows a lot more about its businesses than you and I ever will - should an average investor own it??
I looked at AIG awhile back, it looks incredibly cheap on price to reported earnings, but its balance sheet has $40 billion “other” lines. Is it “other” good stuff or bad stuff? I don’t know. In today’s environment it’s likely to be the latter.
January 22nd, 2008
I talked to Jim Ellis at BusinessWeek about my book Active Value Investing (here is a link to the video). As you will see, if you tie my hand I’d go mute.
At about the same time I talked to TheStreet.com (here is a link to the video) about Apple (AAPL) and Jackson Hewitt (JTX). It was taped right next Wall Street in October 2007.
January 22nd, 2008
I welcome the Bank of America (BAC) acquisition of Countrywide (CFC), as for the first time as I can remember BAC acts as a contrarian investor. I really don’t know what CFC is worth but I know it is worth more in BAC’s hands than as a stand alone company. BAC will be able to provide CFC with liquidity and staying power to survive through the current crisis. In other words it brings continuity to the table (customers and partners that were having second thoughts about dealing with CFC are likely to stick around now).
I am applauding this deal because typically these are done at the top of the market, but BAC found a restraint to wait till things went to hell. Yes, it was early with its first purchase, but picking bottoms is not easy, even for almighty BAC.
January 12th, 2008
I originally wrote this short story to be a part of the article about Jackson Hewitt and IRS’ (possible) allegations that refund anticipation loans create an incentive for tax preparers to commit fraud.
When I was in the third grade, growing up in Murmansk, a city above the Polar Circle in (then) communist Russia, my buddy and I decided to start a business. We pooled our modest funds (mostly lunch money), bought photo paper and chemicals, and borrowed my older brother’s photo camera and photo development machine. This was in the early 1980s, a time before scanners, laser printers and copying machines. We took pictures of music record covers from the likes of Iron Maiden, Jethro Tull and Kiss, developed those pictures and sold them in school during breaks.
The business was going well, we were onto something, there was nothing like this available. We recouped our costs, and had a small profit, until one dark day (it was always dark during long sunless winters in Murmansk). My buddy and I were taken into the principal’s office. We were told a student stole money from another student, and when he was caught he said he stole money to buy our pictures. Suddenly, with this twisted logic we were at fault. Never mind that we were breaking copyright laws. There was no way in early 1980s to obtain copyright, even if we wanted to. We created the incentive to steal.
My father unapologetically told the principal that we were as much at fault as the movie industry and toy retailers — the creators of incentives. Of course, none of that mattered. To appease the school authorities I donated my profit to the World Peace Fund (still not sure where that money went, maybe ended the Cold War? Nah, I doubt it). My buddy and I received an “F” for the behavior, which was not a big downgrade for me since I rarely got a grade much above “C” for behavior.
January 9th, 2008
The avoidance of taxes is the only pursuit that still carries any reward.
John Maynard Keynes
Jackson Hewitt (JTX) declined significantly yesterday on news the IRS proposed regulation to ban refund anticipation loans, or RALs. Fear of the impact the new rules could have on JTX’s business drove it and H&R Block (HRB) down, although HRB faired better as it had already been beaten down by company specific issues stemming from its subprime mortgage business.
RALs are originated to customers who don’t want to wait a couple of weeks to get their tax refund from the IRS, and thus are willing to pay a 2-2.5% (capped at $95) fee to get their money right away. Though RALs are as controversial as payday loans that charge annualized triple digit interest rates, this is not the reason why the IRS is zeroing in them. After all, the IRS mandate is to collect taxes, not to legislate morality.
Continue Reading January 4th, 2008
This article was originally called Will Gold Shine Again?. It was excerpted from my book Active Value Investing and appeared in the Rocky Mountain News. I have no intention of making an argument of where the gold prices will be over next month or five years from now - I simply don’t know. My intention is to dispel this notion that gold was a great investment - it simply not the case, and offer a caution that gold may not be a great investment going forward.
December 22nd, 2007
Denver Post wrote an article about my book Active Value Investing. The question that comes to mind - what am I doing reading my own book (see picture in the article)? I don’t really have a good answer to that question. I’ve read it so many times while writing it that I really cannot read it anymore. Denver Post’s photographer thought it was a good idea. Now that I look at the picture, not sure I agree. It is a good article though, read it.
December 20th, 2007
I spent my youth in Murmansk, a city in the northwest part of Russia (located right above the Arctic Circle). Murmansk owes its existence to the port that, due to the warm Gulf Stream, doesn’t freeze during the long winters,
providing unique access to Russia from the north. During the Cold War, Murmansk’s coordinates must have been on the speed dial of the U.S. military, as it is the headquarters of the Russian Northern Navy Fleet (the headquarters actually are in Severomorsk, a town 20 miles away, but the distinction is rarely made). Fans of Tom Clancy’s The Hunt for Red October may remember Murmansk as the home base for the submarine Red October.
Continue Reading December 15th, 2007
By Vitaliy Katsenelson, CFA
After 16 years of almost no contact with my Russian high school and college friends I stumbled on Odnoklassniki.ru, a website very similar to Classmates.com. I reconnected with a lot of childhood friends. It was a very nostalgic and quite depressing experience as I found out two of my close childhood friends and five classmates died from drinking — most were in their mid-twenties.
The story is the same — drinking a couple days a week leads to drinking every day, get fired, wife leaves, no source of income, sell apartment, money doesn’t last long, start drinking technical alcohol (used to clean engines), death from heart shutting down. What made this even worse: I remember most all of those friends when they were only teenagers. My sister-in-law’s cousins, one is 33 another 41, drinking heavily, ditched by their wives, sold their apartment — well, you know what is coming. I don’t know if living in a city where winter lasts eight months a year has anything to do with it, or just simply Russia being Russia. It is probably that latter. Life expectancy for men is 59; for women is 72. I bet drinking accounts for a very large portion of this gap between men and women. I remember vaguely when I was very young that almost all of my neighbors were drinking. One would get drunk and beat up his wife, so she would hide in our apartment to avoid the beating. Another would pay a regular weekly visit asking for money or alcohol. It always upset me when Americans, after finding out I am Russian, would start talking to me about Russian vodka. Well, I guess Russia deserves that reputation.
December 15th, 2007
Jos A. Bank (JOSB) reported decent numbers yesterday: sales grew 10%. It’s not a blow out number but a respectable number for this environment. Profit margins have expanded as corporate expenses are leveraged across a larger store base, driving earnings growth to 27%.
At some point its advertising expenses will start declining as percent of sales and margins should go up further. At today’s incredibly cheap valuation of 10x 2007 earnings, all the company had to do is be able to fog a mirror - they did a lot more than that. It seems that this performance has legs as same store sales in November came in at 15%.
I wrote several articles in the past, little have changed since. Well, except earnings are up in 30-40%, inventory is not a concern anymore and stock price is back to where it was then.
December 14th, 2007
By Vitaliy Katsenelson
Who would have thought that an almighty Citigroup (C ), a diversified financial giant that should have benefited from the sub-prime mess by scooping up weaker competition at pennies on the dollar, would be taking out a sub-prime no-income verification $7.5 billion convertible preferred loan from Abu Dhabi - a country that most of us can hardly find on the map?I don’t use the word sub-prime lightly, but the 11% coupon on the cost of the Citigroup (C) deal exceeds the 7.5% coupon that Countrywide (CFC) (the US’ largest mortgage originator which is fighting for its existence and supposedly doesn’t have the diversity of Citi’s financial empire) promised to pay Bank of America ( BAC) in the similar convertible preferred deal. And it is no-income verification loan as Citi’s exposure to the alphabet soup problems (SIV, ABS, CDO, CMO, MTV, VH1 – oops I went too far), or in other words everything that went wrong in financial markets over last six months, is very difficult to identify.
Unfortunately it takes years not months for all problem loans to surface from the balance sheet to the income statement. For example, in late 1980s CIti found itself in the center of a Latin American default crisis. It took close to four years for the company to work through the troubled loans.
This is not just another investment from a sovereign foreign entity that should “shore up investor confidence in Citi,” as PR would spin the deal. At 11% interest rate this loan is an act of desperation. Remember, the bank is in the business of making a spread between its borrowing and lending rates.
Unless Citi will be lending at a rate in excess of 11% - a highly unlikely scenario - the purpose of this loan was to fund its dividend for next three quarters. Citi’s management saw what happened to Freddie Mac’s ( FRE) stock – it took a dive – when it announced a 50% dividend cut and decided to take the expensive route instead.
The fallout in financial stocks will create a lot of buying opportunities as lot of great regional banks that were not smart enough to do dumb things are getting lumped in the same bad apple basket as Citi and the like.
November 28th, 2007
In October, I had a great pleasure to be interviewed by two of my favorite Motley Fools: Philip Durell advisor to Motley Fool Inside Value newsletter and Bill Mann co-advisor to Motley Fool Hidden Gems newsletter. In this in depth interview I discuss everything: economy, stocks I like, international investing, practical application of QVG framework, absolute P/E model and of course my book - Active Value Investing: Making Money in Range-Bound Markets.
Continue Reading November 17th, 2007
I was interviewed by George who runs Fat Pitch Financials and Value Investing News. George also rerviewed my book.
Continue Reading November 5th, 2007
In this fund video interview with TheStreet.com I talk about why I don’t think Apple (AAPL) is a buy, why I love Jackson Hewitt (JTX) and my book Active Value Investing.
October 29th, 2007
I like Alan Greenspan, despite writing a critical article about him. It is hard not to admire the guy. He has this avuncular quality about him, he is kind of like your uncle who is super smart, kind and buys you a bicycle on Hanukkah. I’ve been reading his book and I can safely say it is one of the best books on economics I’ve read since Basic Economics by Thomas Sowell.
In the efforts to promote his book, avuncular Al is everywhere. I’ve been told (I don’t have a TV at home) that it is hard to turn on a TV and not see his friendly face at least couple times a day. What has really surprised me is how quickly he learned to speak plain and understandable English. This time around he did not hide behind suprevilosly exorbulant (Ok, I made those two words up) vocabulary. I’ve seen him on CNBC (I have a TV at work) and for the first time in years I did not have to reach out for a dictionary. Also, suddenly he is bearish on the US housing market. The one that (if I understood him right) before was a non issue. In fact now he sounds like a voice of reason. Yes, we got problems!
The lesson here - it is almost pointless listening to a Fed chair while he is on the job because he cannot say what he really thinks as the consequences of that are too high.
October 17th, 2007
If we learned anything over the last couple of months it is that we don’t know the second and third derivative of how badly things will play out.
We knew that the housing market was in the bubble, what we did not know was how its deflation will play out, i.e. commercial market freeze. We did not know that that it would resonate in Germany or that it would cause a run on the bank in England. We did not know that Russia, a country that is supposed to be swimming in cash from oil revenues, will be tinkering with financial crisis again (at least we did not expect it to happen when oil prices at $80).
What we know now is that our economies are a lot more interconnected than we ever imagined and also that the consequences of use of leverage will be found in places we never expect them to be found.
October 11th, 2007
Soon after we purchased Jackson Hewitt (JTX), offices of one of their franchisees was raided by the U.S. Justice Department; the franchisee was accused of falsifying tax returns for thousands of taxpayers. JTX stock collapsed on that news. The risk was that it was a widespread practice and JTX management was complicit with the franchisee and that the brand may have been damaged and lawsuits would follow.We thought otherwise: The management had no incentives to resort to outright spend-time-in-jail type of fraud, they had a great business on their hands; it made no sense for them to do something that stupid.
Though that incident made headlines in the localities where it took place, national media was preoccupied with more important developments at the time (i.e. Paris Hilton going to jail) and thus the JTX’s brand was unscathed. We liked JTX’s management when we purchased the stock, but we were even more impressed with their response to this incident: they hired an ex-IRS commissioner to head an independent internal investigation and clearly communicated to investors about the investigation.
As we expected the IRS did not find anything, management settled the issue with them (basically paying the IRS $1.5 million to go away). Here is an opportunity. The “bad news” (which now was not really bad) drove the stock down to about 12-13 times earnings, but JTX has a handful of growth drivers that should bring earnings growth in mid to high teens for years to come as it only has a 4% market share of a very fragmented market. Management spends every penny of free cash flow to return to shareholders (our kind of management) through a 2.6% dividend yield and stock buyback.
October 11th, 2007
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