Investment Thinking a la Wayne Gretzky
(Guest Commentary by Rick Konrad – April 24, 2011)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick wants to instill in us some fresh thinking for the spring—with a specific discussion on our accounting treatment of intangibles and why it may be doing a disservice to long-term investors. Rick also discusses the dangers of extrapolating historical results, and reminds us that Wayne Gretzky's philosophy of “skating to where the puck is going to be” is the most sensible route to go, despite the difficulty in predicting future earnings. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Walking on Broken Glass” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
First of all, whatever your faith may be, I wish you much joy and happiness of the season. Easter, or Passover, as springtime events mark a blossom time for souls. It marks a time for fresh thinking and hope.
Philosophically, I have always liked to apply a mosaic of ideas to my investments. Often, we may find ourselves somewhat lost, making excuses for securities that have failed to deliver or their associated managements. Old platitudes and beliefs need to be re-examined and biases need to be shaken. Though it is remarkably comfortable to run with the pack, such blind faith rarely is associated with earning supra-normal profits.
One of the more amusing (or disturbing) signs of blind faith seems to be part of the Apple (AAPL) cult. I was somewhat amused by this Yahoo Finance Message I caught earlier today:
imho best bet on Apple is Jan 2012 400's at about 18
I will bet my virginity that Apple price per share is over 418 by o/e in January.
Maybe, spring has truly sprung. In behavioral finance terms, there seems to evidence of over-confidence, or at least over-exuberance. Though none of us can accurately predict stock prices with perfect timing, most of us can attempt to come up with a reasonable intrinsic value for a stock, given a set of assumptions. Let's think about this for a second.
Much of our training in security analysis, unfortunately, relies on extrapolation of previous trends. A stock that has a record of poor profitability, tends to be accorded more of the same in all but the most radical financial models. Ditto for those fortunate companies that have great profitability. Many of us rely on screens to come up with new ideas, yet, this only result in further extrapolation of historical trends. Maybe some fresh thinking is called for!
One of hockey's great stars was Wayne Gretzky who identified his most important ability as,” I skate to where the puck is going to be, not where it has been.” In investment terms, this means:
Where the Puck Is
- Focus on historical balance sheets and financials
- Focus on the prior track record of the business
- Focus on how the company is valued on current metrics
- While thought is given to the future of the business, the preponderance of weight is given to where the business is now.
Where the Puck Is Going to Be
- Focus on future balance sheets and financials
- Focus on what will be the future track record of the business
- Focus on how the company is valued on future metrics
- Preponderance of weight is given to where business will be
Most of us spend far too much time dwelling on where a business was rather than where it might be in the future. Realistically, there are only a select number of opportunities in which to make a bet that looks quite markedly different from the past. However, when we think we find these, there is a need for a very large upside to compensate for the fact that the future might not be nearly what we thought.
Investment analysts tend to be somewhat uncomfortable when we think of “big picture” kind of ideas. We are contented to deal with quantitative models that are largely designed, through spreadsheets, to discount future cash flows for our decision-making. Yet, plugging numbers into a DCF model depends on two highly subjective assumptions:
- The sustainability and growth of the cash flows
- The discount rate that is applied to those cash flows
Notwithstanding our focus on numbers, there is tangible importance in intangible assets like corporate reputation, quality, and sustainability. Value is created through active intangible asset management as well as future cash flows. As Abe Lincoln once observed, “Reputation is like fine china-once broke, it's very hard to repair.”
These cash flow assumptions that we plug into DCF models are highly dependent on an understanding of the underlying corporate reputation structure. Though regurgitating historical information into the future is relatively easy, we may be able to glean information from better understanding the changing competitive landscape and the repercussions of changing corporate reputations on growth rates, and operating costs, and hence, the sustainability and growth of future cash flows. Making a reasoned judgment about the company involved and investors' expectations is critical to these decisions.
In many ways, competitive strategy and reputation analysis lie at the heart of security analysis. Shifts in reputation will lead to a revised outlook for sales, costs, or capital investments-all important value triggers. The mantra of financial management is to create value by investing at rates above the cost of capital. Indeed, sustainable value creation is the signature of competitive advantage. I believe that companies with premier reputations enjoy a lower cost of capital. Hence, a positive business reputation can lower the hurdle for creating value. Since a company's competitive advantage hinges squarely on the quality and execution of its strategies, analysis of a company's reputation is vital to planning and decision-making.
Buffett has said, “The investor of today does not profit from yesterday's growth.” Consequently, a great deal of our thinking should be dedicated to avoiding the pitfall of anchoring our expectations based on past views. Rather, we should challenge these precepts with fresh perspectives, many of which are sourced from understanding the competitive landscape.
I think that our accounting systems, largely unchanged for the last 50 years have done us a disservice by focusing on short-term profits measurement at the expense of intangible assets. In doing so, this may marginalize marketing and its contribution to shareholder value. The goals of marketing have traditionally been formulated in customer attitude or sales performance terms rather than the effect on intangible or reputational value of the firm. Though the effects of advertising on sales have been researched in depth, there has been little effort to study the direct impact of advertising spending on firm value, beyond its effect on sales revenues and profits.
Perhaps, some non-financial indicators of investments in intangible assets such as customer satisfaction may be a better predictor of future financial performance than historical accounting measures. Advertising attempts to differentiate a firm's products from those of its competitors, thus creating brand equity for its products. This equity, created through marketing and ostensibly directed at customers and prospect may well spill over into investor behavior as well.
Brand awareness and perceived brand quality may well spill over to demand for stocks of these companies. In some ways, advertising may act as a signal of financial well-being or competitive viability of a firm. Celebrity endorsement may well have an influence on firm valuation. Recently, Weight Watchers International (WTW) enjoyed a spectacular rise, which seemed to coincide with a reinvigorated ad campaign as well as the endorsement of a beautiful and less bountiful Jennifer Hudson.
As I said, springtime is a great time for fresh thinking and at least tearing away some old vines and misplaced beliefs. At the beginning of the year, I was fortunate in applying some fresh thinking to Supervalu (SVU), a company which is just beginning to overcome some operational as well as financial challenges. Our guidepost in SVU was a management that was finally beginning to “get it” and a fabulous free cash flow cushion (FCF yield of about 20%) that allowed the business to survive its miscues. We continue to believe that management may monetize its Save-A-Lot subsidiary which could bring us into the mid-teens. We continue to hold both the stock and some SVU bonds.
Disclaimer: I, my family, or clients have a position in Supervalu Inc.