Monday, 29 March 2010
Valuation Models that better capture the meaning of “fundamental” financial analysis: the cash flow forecast and the discounted cash flow (DCF)
The unbearable lightness of value
As global markets have risen in the past year, some observers are at a loss to reconcile the trend with what they see as still soft fundamentals. At the macroeconomic level, such fundamentals would include unemployment, debt on a variety of levels, deficits of a variety of kinds. At the microeconomic level, fundamentals have to do with free cash flows and the relation between these and the value of a business. Watching global markets rise while fundamentals remain questionable, one wonders if the way we look at fundamentals, at least in the microeconomic sense, is outdated. Without becoming overly dramatic, I wonder if corporate finance theory is losing some of its meaning in an environment in which option value, rather than operating profit, becomes the dominant strain.
There are no models that better capture the meaning of “fundamental” financial analysis than the cash flow forecast and the discounted cash flow (DCF) valuation method that is its close affiliate. And in the DCF method, there is a permanence implied, that nowadays seems increasingly flawed. When a multi-year financial model is created, and when an enterprise valuation is estimated at the end of such a timeframe and discounted back to the present, we have an understanding that the business underlying this exercise will be more or less the same business in the future. For a widget producer, say, while there will be new widget competition, new widget markets, fluctuations in profit margins and economic cycles, it is nevertheless a given – inherent in the financial forecast – that there will always be widgets. The fluctuations are addressed with risk-adjusted discount rates, and with fine-tuned details and line-items, but widget production does not go away.
Yet what business, what industry segment, can we really point to nowadays, and with any confidence determine that its widget manufacture will continue? Ten years ago, we felt pretty good about newspapers, radio, and television. The telephone system. With hindsight, what did those AT&T financial forecasts mean? What do financial forecasts for newspapers and television mean now? I am unfair, I know, choosing my examples from among the vulnerable. We have had a technology revolution, after all… but is this era showing any signs of pause? With rumors going around about cloud computing, might Windows not become a niche product just like landline telephones are quickly becoming?
Media and technology are isolated and extreme cases, I suppose. I guess we could confidently assemble a long term perspective of the energy segment then? Or biotechnology? For that matter, healthcare? Basic manufacturing? There is some degree of permanence in real estate, as roofs over our heads will probably not be rendered obsolete within a 5-year forecast model, but that is sort of a sore subject nowadays, isn’t it… using real estate and financial forecasting in the same phrase together. I mean, considering what happened.
Before anyone jumps to the wrong conclusion in these musings, assuming incorrectly that such thinking is bound to lead to inaction if not downright paralysis, my point is not that value does not exist or is impossible to measure. Pagers had value, newspapers still do. Even Netscape (where is it now?) is discussed today as a success story, and the media sector is not going away. But the financial value in these and other assets, or asset classes, may be seen less through the filter of fundamentals, perhaps, and more on the basis of steps along the way of progress. What emerges, and what has greater value all the time in this affair, is optionality.
Option value: the unknown but real future opportunity that a current business makes possible. According to option theory, option value increase as volatility increases. Perhaps the rise in global financial markets that we have witnessed in the past twelve months, which seems to have occurred even as certain risks have mounted, serves as introduction to a new investor perspective, by which value rises not despite, but because of, uncertainty, fluctuation, and constant change.
http://discourseandnotes.com/blog/2010/03/28/the-unbearable-lightness-of-value-2/
Will Petdag close above or below RM 9.00 today?
It tested the MR 9.00 resistance on 3 occasions since October 2009. This morning, it penetrated this level.
Check the charts occasionally to sense mob hysteria or panic at work
Some people in the markets use graphs of previous stocks or commodity movements in order to predict future price movements. They are called "technicians" or "chartists." They spend a lot of time pouring over the historic price movements and the formations these show on their charts as a way to predict what will happen next.
Ordinarily, I do not use charts to trade. Occasionally, I will turn to them as a way to see what has been happening and to check facts if I sense mob hysteria or panic at work.
Charts sometimes reveal a beeline rise, an indication that prices have increased far beyond actual value. It means that people have lost perspective. It shows the level of the hysteria. I know that prices will eventually return to the appropriate level, so I sell short. You need to be careful, though, that you are not selling short simply because prices are high. Never sell short unless prices are astronomically expensive, AND you detect negative change coming.
You can see panic in falling prices when you see them collapsing straight down day after day for extended periods. Historically, long periods of selling have ended in "selling climaxes" when everyone finally panics and dumps to get out of the market at any price no matter what the fundamental reality might be. Large price declines across the board should attract your attention.
A good rule of thumb is to sell during times of market hysteria and buy during times of panic. Always remember to buy low and sell high.
Ref:
Jim Rogers
A Gift to My Children
Ordinarily, I do not use charts to trade. Occasionally, I will turn to them as a way to see what has been happening and to check facts if I sense mob hysteria or panic at work.
Charts sometimes reveal a beeline rise, an indication that prices have increased far beyond actual value. It means that people have lost perspective. It shows the level of the hysteria. I know that prices will eventually return to the appropriate level, so I sell short. You need to be careful, though, that you are not selling short simply because prices are high. Never sell short unless prices are astronomically expensive, AND you detect negative change coming.
You can see panic in falling prices when you see them collapsing straight down day after day for extended periods. Historically, long periods of selling have ended in "selling climaxes" when everyone finally panics and dumps to get out of the market at any price no matter what the fundamental reality might be. Large price declines across the board should attract your attention.
A good rule of thumb is to sell during times of market hysteria and buy during times of panic. Always remember to buy low and sell high.
Ref:
Jim Rogers
A Gift to My Children
Selling Hysteria
For the most part, it is in short-term trades that prices are driven by emotion. Mid-term and long-term investments are usually influenced more by the fundamentals.
Bubbles burst in the wake of hysteria, while plummeting prices usually end in panic.
You can see panic in falling prices when you see them collapsing straight down day after day for extended periods. Historically, long periods of selling have ended in "selling climaxes" when everyone finally panics and dumps to get out of the market at any price no matter what the fundamental reality might be.
Large price declines across the board should attract your attention. A good rule of thumb is to sell during times of market hysteria and buy during times of panic.
Always remember to buy low and sell high. It sounds so simple, but it is extremely difficult. Just keep this dictum in mind always - especially when your emotions are getting the best of you.
Ref:
Jim Rogers
A Gift to My Children
Bubbles burst in the wake of hysteria, while plummeting prices usually end in panic.
You can see panic in falling prices when you see them collapsing straight down day after day for extended periods. Historically, long periods of selling have ended in "selling climaxes" when everyone finally panics and dumps to get out of the market at any price no matter what the fundamental reality might be.
Large price declines across the board should attract your attention. A good rule of thumb is to sell during times of market hysteria and buy during times of panic.
Always remember to buy low and sell high. It sounds so simple, but it is extremely difficult. Just keep this dictum in mind always - especially when your emotions are getting the best of you.
Ref:
Jim Rogers
A Gift to My Children
Do not panic; learn the psychology
To be a successful investor, you really need to understand psychology as well as history and philosophy. Very often emotions drive the market up or down. Remember that economies and stock markets are two different things.
As Paul Samuelson,l the Nobel Prize winning economists, once put it, "The stock market has anticipated nine of the last five recessions."
China's economy, for example, has been growing rapidly for years now, yet its stock market declined consistently for four years between 2001 and 2005. The public overreacting to positive or negative news reports, will buy or sell short at the wrong time. Investor psychology can accelerate such trends int he market.
Anybody can feel panicky. Losing your perspective in the midst of market panic is equivalent to losing your money in that market.
Ref:
Jim Rogers
A Gift to My Children
As Paul Samuelson,l the Nobel Prize winning economists, once put it, "The stock market has anticipated nine of the last five recessions."
China's economy, for example, has been growing rapidly for years now, yet its stock market declined consistently for four years between 2001 and 2005. The public overreacting to positive or negative news reports, will buy or sell short at the wrong time. Investor psychology can accelerate such trends int he market.
Anybody can feel panicky. Losing your perspective in the midst of market panic is equivalent to losing your money in that market.
Ref:
Jim Rogers
A Gift to My Children
Alan Greenspan on the Financial Collapse
March 23, 2010 | Comments (81)
Former Federal Reserve Chairman Alan Greenspan just published a 66-page letter on the causes of the financial meltdown and how to avoid a repeat. He presents some great points, and several ridiculous ones as well. Here are a few of each.
"The firms accounted for an estimated 40% of all subprime mortgage securities … during 2003 and 2004. That was an estimated five times their share of newly purchased and retained in 2002, implying that a significant proportion of the increased demand for subprime mortgage-backed securities during the years 2003-2004 was effectively politically mandated ..."
Wall Street gets vilified for blowing up the financial system. As it should. But a big part of the mortgage mess had nothing to do with Wall Street. It started with commercial banks making shady loans and ended with Fannie and Freddie's political obligation to buy up these loans in bulk. What's scary is there isn't a plan on what to do with these two rascals. Functionally,nothing has changed since they collapsed.
2. On the role of the rating agencies:
"[A]n inordinately large part of investment management subcontracted to the 'safe harbor' risk designations of the credit rating agencies. No further judgment was required of investment officers who believed they were effectively held harmless by the judgments of government-sanctioned rating organizations."
It's easy to have no sympathy for those who bought collateralized debt obligations only to learn they were filled with packing peanuts. And I don't. But stupidity wasn't these people's shortfall, to their credit. It was relying on the word of the ratings agencies -- Moody's (NYSE:MCO), Standard & Poor's, and Fitch -- that told them everything was fine and well. And as Greenspan points out, ratings agencies are government-sanctioned entities, so competition for good, high-quality analysis gets stifled.
3. On regulating financial markets:
"In dealing with nonbanks that come in all varieties under the label of 'shadow banking,' it is probably best to regulate financial products rather than institutions."
Bingo. Don't simply regulate Goldman Sachs (NYSE: GS). Its bankers will throw up smokescreens all day around regulators trying to decode its balance sheet. Start at the bottom and regulate (or ban) things like credit default swaps. The only way you'll outsmart these guys is to regulate from the bottom up, not the top down.
4. On "too big to fail":
"Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution."
Hear that, JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon? Now quit acting like civilization will be forced back into hunting and gathering if four banks don't control the economy.
5. On crisis forecasting:
"Forecasters as a group will almost certainly miss the onset of the next financial crisis, as they have so often in the past and I presume any newly designated 'systemic regulator' will also."
I'm like my colleague Matt Koppenheffer on this one: The thought of risk-regulation committees and advisory boards makes me nauseated. Most regulators didn't even acknowledge anything was wrong until chaos was everywhere. And once you realize a bank such as Citigroup (NYSE: C) or Bank of America (NYSE: BAC) is in deep water, it's too late. You've got to install firm rules that prevent insanity in the first place, rather than rely on crisis committees or reactionary policies the way we did in 2008.
Ridiculous points
1. On the Fed's role in the housing boom:
1. On the Fed's role in the housing boom:
"The global house price bubble was a consequence of lower interest rates, but it was long-term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom. … No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate ..."
If you assume everyone uses a 30-year fixed-rate mortgage, he's right. But how about the roughly one-third of borrowers in 2005 who used adjustable-rate mortgages linked to short-term interest rates set by the Fed? These borrowers represent some of the most egregious excesses of the housing boom, and they couldn't have done it without you, Al.
2. On the impracticality of controlling bubbles:
"At some rate, monetary policy can crush any bubble. If not 6 1/2%, try 20%, or 50% for that matter. Any bubble can be crushed, but the state of prosperity will be an inevitable victim."
Let's look at how this has played out in the past. Facing an inflation bubble in the early 1980s, Greenspan's predecessor, Paul Volcker, raised interest rates to 20%. That hurt for a while, but he's now considered an economic hero for doing it. Inflation collapsed, and real growth boomed. He looked past the short run to save the long run. Greenspan, on the other hand, let this bubble burn itself out. The result, in his own words, was "the most virulent global financial crisis ever." But we preserved prosperity in 2006, people, so apparently it was all worth it.
3. On choices:
"Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible. Assuaging their aftermath seems the best we can hope for."
It's a bit dramatic to assume we can pick either crippling bubbles or central planning, but nothing else. You can simultaneously have dynamic free markets and common-sense rules that prevent pizza delivery guys from living like they're on MTV Cribs. We had something close to this from the end of World War II up until the late '90s. And it was awesome. Bubbles are a natural part of human behavior. That's a given. But it's pretty weak to just roll over and accept their wrath as inevitable.
What do you think? How responsible is Greenspan for the financial meltdown, and what should he have done differently?
The Dark Secret of the Best-Performing Stocks
By Matt Koppenheffer
At this point, I've seen this list of the past decade's top-performing stocks so many times that I can recite most of them from memory. But there's good reason to keep picking apart these top performers, because any one of them had the potential to turn a mediocre portfolio into a market-beater.
Here's a peek at 10 of the top 25 performing stocks of the past decade:
Company | Price Change Jan. 1, 2000, to Jan. 1, 2010 |
|---|---|
Bally Technologies | 5,975% |
5,917% | |
Southwestern Energy | 5,776% |
Clean Harbors | 4,669% |
Deckers Outdoor | 3,775% |
Jos. A Bank Clothiers | 3,196% |
Range Resources | 2,246% |
FTI Consulting | 2,022% |
CarMax | 1,997% |
1,960% |
Source: Capital IQ, a Standard & Poor's company.
The list may look pretty familiar, but what you may not know is that these companies, and many of the decade's other top performers, share a dark secret.
Skeletons in the closet
If you're thinking I'm going to say that all of the companies above were small and that they beat the pants off of large, well-known stocks like Procter & Gamble (NYSE: PG) and Disney(NYSE: DIS) (which returned 10.7% and 10.3%, respectively), I'm not. It's true, but a number of my colleagues have already done a great job highlighting that very important aspect.
If you're thinking I'm going to say that all of the companies above were small and that they beat the pants off of large, well-known stocks like Procter & Gamble (NYSE: PG) and Disney(NYSE: DIS) (which returned 10.7% and 10.3%, respectively), I'm not. It's true, but a number of my colleagues have already done a great job highlighting that very important aspect.
So what is the secret, then? Instead of simply telling you, let's take another look at the companies listed above and see if you can figure it out.
Company | Price Change Jan. 1, 1998, to Jan. 1, 2000 | Return on Equity in 1999 | Debt-to-Equity in Early 2000 |
|---|---|---|---|
Bally Technologies | (84.1%) | Unprofitable | Negative book value |
XTO Energy | (45.5%) | 19.5% | 340.8% |
Southwestern Energy | (49%) | 5.3% | 140.5% |
Clean Harbors | (20%) | Unprofitable | 230.2% |
Deckers Outdoor | (65%) | 5.3% | 14.6% |
JoS. A. Bank Clothiers | (44.2%) | 3.2% | 35.9% |
Range Resources | (80.4%) | Unprofitable | 417.5% |
FTI Consulting | (60%) | 2.9% | 206.7% |
CarMax | (74.3%) | Unprofitable | 62.2% |
Terra Industries | (88%) | Unprofitable | 77.7% |
Source: Capital IQ, a Standard & Poor's company.
Now what would you say ties all of these top-performing companies together?
If you said something to the tune of "they looked like terrible investments," then you get a gold star. Even a quick glance at that chart would send chills up the spine of most fundamental-oriented investors. Many of the companies were unprofitable, the ones that weren't produced lackluster returns on capital, and quite a few were swimming in debt.
Maybe it's not so surprising, then, that the market hated these stocks at the time. Those are some massive declines posted above, and bear in mind that this was over a period when the S&P jumped more than 50%.
Time to scrap everything we know?
Does this mean that we should forget about looking for high-quality companies trading at reasonable prices in favor of looking in the garbage bin? I don't think so.
Does this mean that we should forget about looking for high-quality companies trading at reasonable prices in favor of looking in the garbage bin? I don't think so.
The list of the decade's top-performing stocks isn't the only place where lousy returns on equity and high debt levels show up. You can also find numbers that look like that on a list of the decade's bankruptcies.
According to Capital IQ, there were 667 publicly traded companies with market caps above $10 million that filed for bankruptcy over the past decade. In 2000, only 22 of those companies could claim a return on equity above 15% and debt-to-equity below 50%. The rest of the companies that went belly up sported numbers that looked a lot like those in the chart above.
In other words, taking fliers on companies with ugly-looking financials could land you a massive winner, but it also gives you a big chance of taking hefty losses.
Swing at good pitches
By sticking to investing in reasonably capitalized and solidly profitable companies that are trading at attractive prices, we may miss out on some of the biggest winners, but we also vastly reduce the chances of sticking ourselves with clunkers headed toward bankruptcy.
By sticking to investing in reasonably capitalized and solidly profitable companies that are trading at attractive prices, we may miss out on some of the biggest winners, but we also vastly reduce the chances of sticking ourselves with clunkers headed toward bankruptcy.
And don't worry, there are still plenty of opportunities for big returns. With gains of 9,211% and 7,024%, respectively, Green Mountain Coffee Roasters (Nasdaq: GMCR) andHansen Natural (Nasdaq: HANS) were two of the very best performing stocks of the decade, and both would have fit a "high quality at a reasonable price" strategy back in 2000.
Of course, even companies that produce good-looking numbers can end up being poor investments. Ten years ago, the numbers all seemed to line up for American Capital(Nasdaq: ACAS) and Ethan Allen Interiors, but both stocks ended up getting clobbered.
That's why the team at the Motley Fool Hidden Gems newsletter not only focuses on companies that produce attractive financial returns, but also digs in to evaluate intangibles like competitive moat, growth opportunities, and management effectiveness. The team's research recently led it to buy shares of a fashion retailer for the newsletter's real-money portfolio.
Subscribe to:
Posts (Atom)