I remember when I was fresh out of my undergraduate studies. I applied for a sell-side equity research position. I interviewed with a head sector analyst, and I remember the first question oh so well: What is a gross margin?
It was strange. I couldn’t tell if he was joking or not. Of course I knew what a gross margin was, but was this a trick? The interview couldn’t be this easy, right? Well, after responding that a firm’s gross margin is revenue less cost of goods sold divided by revenue, let’s say that he was impressed.
But I wasn’t sure why.
To me, understanding what makes up a gross margin or operating margin or free cash flow margin or any margin, for that matter, is simply par for the course for anyone involved in the stock markets. Were other candidates getting this wrong?
Boy did I have a lot to learn about the “real” world. It took me a while to learn that many investors haven’t even seen an income statement, let alone a balance sheet or cash flow statement. Some investors may not even know where to find them (you can find them in regulatory filings called the 10-K and 10-Q, or in the quarterly press releases for many firms that pride themselves on transparency).
It is a scary proposition.
But let’s think about this. How can the academic community possibly maintain that the markets are efficient when we know that most investors don’t know basic financial analysis? Or worse, these investors are trusting others to lead them that shouldn’t be leading themselves?
Not to pick on the “Bogleheads,” but the entire indexing community believes that the market’s assessment of a company’s price equals the company’s intrinsic value. How did Vanguard possibly convince investors of this? How? I know this not to be true. Price almost never equals value.
It doesn’t take much to reason through it either. If, for example, you provided all relevant and necessary information, a large portion of the investment community (larger than you might think) won’t know how to use such information to calculate intrinsic value correctly. Because assessing intrinsic value involves making forecasts about the future, those that do know how to apply the data would arrive at a range of fair value estimates depending on their various opinions.
But this is only to be expected, right? There is no universal fair value estimate of a company, but even that might be new “news” to some. Only those that have the greatest amount of experience in calculating an intrinsic value estimate will get the closest to estimating the “true” worth of a firm. It’s a fine blend between science (mathematical finance) and art (making forecasts), something I preach all the time. You have to get both right. There are no two ways around it.
This very concept itself speaks to the importance of using a range of fair value outcomes in stock analysis. For example, it is much more appropriate to say that a company is worth between $50 and $70 per share than to say it is worth precisely $60. All value is based on the future, and the future has yet to be written.
But yet how many investors don’t know this either?
The individual investor appears to be so lost today that, even if he or she comes across the “right” way to think about things, he or she wouldn’t be able to recognize it. Many still believe that investing is parking money in a company they like and “hoping” that it will work out.
Many investors may not even remember the dot-com bubble and then-attorney general Elliot Spitzer’s Global Research Analyst Settlement, which encouraged independent thinking and built the backbone of independent stock research. This was just a few years ago in 2003! Look it up.
Have we completely forgotten about what is important? An independent, unbiased and highly-informed opinion is the only one worth paying for. Biased opinions are supposed to be free – they aren’t worth much, if anything.
Absent income considerations, investing is about identifying mispriced assets that have a high likelihood of price-to-fair value convergence. I’m not sure that indexing is even investing – it’s actually closer to playing the “greater fool” theory than one might think. The market simply gets overvalued at times. Again, have we forgotten about the dot-com bubble?
But even if investors prescribe to the efficient markets hypothesis, why would they want to own the market at the theorized fair value anyway? The absolute core of investing is buying a $1 for $0.50. This is what Warren Buffett preaches. In investing, we want to buy the market or a stock at a bargain – not at fair value! Where’s the margin of safety in that?
Yet, there are hundreds of billions, if not trillions of dollars, tracking indexes out there. How can this be? How is this happening? Why do we think that the equity markets will only go up? Remember when housing prices only went up…right before they collapsed? This is what keeps me up at night. What if we find out during the next 10, 20, 50, or 100 years that the stock market doesn’t always go up?
Would you be surprised?
Clearly, the investment community needs help, and we’re working to help investors find the right answer, not just any answer. You’d be surprised about how many may not know the difference, nor care to know the difference.
All that said, in surveying the news the past few days, I continue to be impressed by Apple’s (AAPL) share price performance. One of the largest positions in both newsletter portfolios is now trading north of $130 per share! Between the revenue jump from wearable technologies and the prospect of an Apple electric car, we continue to expect big things from the iPhone maker.
Though it shouldn’t be, it is a shame that I have to mention Apple as an example of the efficacy of the Valuentum process, because, well, it’s Apple. Everyone knows Apple. Doesn’t an investment process worth paying for have to consider highly exotic instruments on underfollowed companies to be successful? Umm….No.
How did this get into investors’ minds?
Remember, investing is about identifying mispriced assets. I’d like to see those recommending emerging market equities walk me through the reasoning why those high-risk individual equities that comprise emerging market funds are a great “buy.” I’m pretty confident they wouldn’t know where to start.
You don’t need to look into micro-caps and emerging market equities to find big winners. You just need to know how to identify mispriced assets and assess the likelihood of price-to-fair value convergence. It doesn’t matter how big the company is or where it’s located – going outside your comfort zone means you’re just taking on more risk.
Risk doesn’t always equal reward. Financial crisis, anyone?
In yet more news, the Fed, despite all of its efforts to be transparent, continues its Fed speak. Check out this gem from Ms. Yellen:
The FOMC’s assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis.
“Will at some point begin considering?”
It sounds as though the Committee isn’t even at the point yet to even begin considering an increase in the target range for the federal funds rate. From my point of view, we have a long way to go before rate hikes become a reality, especially in the context of falling input prices from crude oil to iron ore and beyond.
Though some stocks are becoming ever-more risky at nosebleed prices, yield-sensitive equities appear to have more room to run, even if they aren’t trading at attractive valuations. Remember, price is what you pay and value is what you get – and price almost never equals value! The thirst for income has pushed some high-yielding equities to uncomfortable levels, to say the least.
The housing markets continue to perform well.
In its fiscal first quarter ending January 31, 2015, Toll Brothers (TOL) witnessed net signed contracts advance 24% and 16% in dollars and units, respectively. The average price of net signed contracts increased nicely to $821.5k from $766.1k in last year’s quarter. The firm also raised the low end of its home delivery target for fiscal 2015, to the range of 5.2k-6k homes (was 5k-6k previously) and indicated that “momentum continues to build” heading into the spring selling season. Meritage (MTH) also noted a very strong month of January for orders, showcasing a near-50% jump!
Home improvement giant Home Depot (HD) also revealed underlying strength in the consumer and housing markets. The company posted a 7.9% comparable store sales growth number in the calendar fourth quarter, and an 8.9% increase in US comps. These are simply fantastic numbers for a company of Home Depot’s size, and management reiterated the recovering US housing market as the primary driver. Comparable store sales growth of 3.3%-4.5% is expected in fiscal 2015, but we think the home improvement retailer is being conservative. With its shares trading at 20+ times fiscal 2016 earnings, however, now is hardly an attractive time for an entry point in Home Depot.
This spring selling season has the makings of being the best since the Great Recession.