August 2003
Especially over the short-term, investment returns are driven
by the incremental change in investor's expectations.
While this statement alone seems easy enough to grasp, understanding how it affects securities prices and our subsequent investment decisions at Front Street is critical. A huge shift in expectations has recently occurred that is primarily hinged upon the US economy bouncing back soon. On the surface, the market's rapid jump sadly reinforces the false notion that the market is just a random casino-like game. We think that is a simplistic explanation. It is just that the market is made up of real live human beings! There is no question that we are emotional entities and sometimes react in unpredictable ways. However, as you dig deeper, the market's recent move shows how powerful a simple shift in the underlying assumptions that ultimately drive the corporate bottom-line can be. So, from seemingly out of nowhere, in a very short stretch of time, some investors have seen their stock portfolio magically pop 20%+. Once again, investors have become enamored with many stocks that, in our view, show very little investment merit.
The purpose of this month's newsletter is to show how we use "expectations-based" analysis to help us make solid investment decisions. The best way I can think of to illustrate this concept is to show how changes in certain assumptions and expectations can quickly alter a company's stock price. The following analysis of Intel tells a familiar story of late. In the end, this is a cautious tale of what goes up can just as easily go down.
Intel - the drivers inside
From its lows of nearly $15 per share as recently as six months ago, Intel's stock price has jumped 70% in value. Arguably one of the best companies around with its highly-educated managers, leading edge research-focused culture and wonderful, near-monopolistic position in the PC chip business, Intel is a company that is justifiably the envy of many. But, over the past 3 years, its stock price has dropped from a high of $65 per share to around $25. Put another way, it's down over 60% from its high. This doesn't come as a big surprise to most investors given that Intel was (and is) held by many individuals or their mutual funds. So its jump in price from $15 to $25 is very welcomed, indeed! But it begs a few important questions. Which price is right? What is the risk of a roller-coaster-like return back to $15 per share or worse?
Intel, in its heyday, had sales of around $33 billion per year. Three years later its sales are down $6 billion. They responded like any responsible management should by adjusting their cost structure. As a result of these tough adjustments, they are still profitable, albeit with significantly lower margins. Obviously, this is a cyclical industry (a fact completely ignored by investors during the bubble!) and variations should be expected. This year, Intel is likely to earn nearly $0.50 per share in profits, which translates to a P/E ratio of 50. At its peak it earned $1.00 per share, giving it a P/E ratio of 65. Not too different really, except for the tiny fact that it only earns half as much today!
So how can investors, one month, think $15 per share is the right price, and then only six short months later, think that $25 is right?
Roller-coaster risks are everywhere
Well, here is our best answer. Given the basic drivers of profitability, namely, sales and profit margins, obviously investors must believe that Intel is going to ramp up sales and subsequently increase its margins. By how much? Our calculations show that the market today is assuming a return to peak levels of sales of $33 billion within a couple of years and achieve profit margins of yesteryear within that same span of time. These are the expectations. And they are fully assumed in today's $25 price for Intel. In other words, if they happen, investor's returns will be reasonable, but we don't feel they are properly compensated for the obvious risk that the future doesn't unfold as neatly planned. But the expectations have definitely shifted, countless stories have quickly shown up in the newspapers citing a new bull market, interviews on CNBC are going strong and the brokerage firms have produced reports touting stocks. And, predictably, the "smart money" will begin to sell its shares to the under-thinking, under-informed, hope-filled investors.
Principles don't change
As money managers, our main function is to take these expectations and assess them in a rational, business-like fashion and then decide if they are right or wrong. These types of decisions go to the heart of our job as portfolio managers. At $25 per share, in our view (and that is the only view on which we can responsibly base our decisions concerning other people's money), the expectations embedded in Intel's stock price by the collective brain of the market are too rosy. In today's market, rosy expectations are not uncommon. In other words, we think roller-coaster-like risks are all over the place.
At Front Street, we understand that educated, hard-working, smart people all around the world are busy writing reports, analyzing industry shifts and expending a huge amount of time and energy to gain a thorough understanding of super-complicated topics. It is illogical and arrogant to think that John and I could independently match the breadth of their work. But as portfolio managers, our huge advantage is that we have the flexibility, discipline and responsibility to only invest in situations we can understand, and most importantly, avoid those that we don't. Literally, we don't need, nor is it physically possible, to have a complete understanding of each and every stock traded in the US. For that matter, we don't need to understand the intricacies of the housing market in Arizona, the car industry in Europe or the state of the chip manufacturing industry in Taiwan. However, once we decide that a certain situation has serious investment merit, the research process begins. Then our specific viewpoint and thorough understanding matters a lot.
In the end, managing money successfully is about minimizing mistakes. Since March 2000, if investors had simply avoided the obviously overvalued technology stocks (and the mutual funds that held them) and stayed away from highly priced large-cap darlings (and the mutual funds that held them, too), most investors wouldn't be looking at the huge losses they subsequently suffered. Keeping a portfolio intact during this span was more about remembering the importance of maintaining a balanced, diversified portfolio and doing a basic risk vs. reward analysis, than about brilliant stock picking. In other words, long-term wealth creation is driven by minimizing mistakes, accurately judging the implicit expectations in securities prices and by constantly worrying about downside risk. It still holds true, three years later. And it will hold true 100 years from now, too.
Low expectations investing
One of our approaches to finding interesting investment ideas is to go where the expectations are low, and in our view, too low. The following headlines are the kind that can catch our attention: ABC's sales growth slowed in past quarter. XYZ's largest customer just filed for bankruptcy or DEF's stock fell over 25% today. These are the types of circumstances that open up opportunities for value-seeking investors like us. We are not the kind of money managers who reflexively buy into rallies or automatically sell into weakness. At times we might, but as a fundamental principle, we have our minds focused on simply finding 30 to 40 solid investment opportunities that possess ample upside potential while at the same time give us the comfort of preserving capital. It sounds easier than it is, by the way, especially in today's market. The search continues...
"If you don't lose money, most of the remaining alternatives are pretty good ones." - Joel Greenblatt, Gotham Capital
Jason P. Tank, CFA
jason@frontstreet.com