Emotions, Intrinsic value and Dividend Clienteles: The Apple trade postscript

Now that I have read some of the reactions to my post on "folding" on Apple, I would like to respond to at least three issues that were raised in these responses. The first was that my sale of Apple seemed to be grounded more in emotional than in fundamental reasons. The second and related point was that the sale of the stock at a price that was below my own estimate of intrinsic value was not consistent with intrinsic value investing. The third was a more general question of whether or when I would return to the fold of Apple stockholders.

1. The "emotional" trade
To those who have charged me with being "emotional" on this trade, rather than "rational", I plead guilty, but I do think that I made clear in both my posts on Apple that I was incapable of being rational in my decisions on the stock. In fact, I will go further and argue that if the sale of Apple was partly driven by emotional factors, the original investment in Apple was also not entirely a "rational" one. It is difficult for those who have grown up with Apple as the dominant player in the smart phone and tablet market to visualize Apple as it was in early 1997: a company that seemed to have run out of ideas, with new products that no one wanted to buy, facing  a dominant player (Microsoft) that was threatening to eat them as a snack. I would love to tell you that I did an intrinsic valuation of Apple in 1997, saw the miraculous recovery in my crystal ball, and bought the stock but I did not. The truth is that I bought Apple for three reasons and the first two could only be classified as emotional.

1. The first was the "pity" factor. I bought Apple stock because I felt sorry for the company and was perfectly willing to write off my investment in the stock as my charitable contribution for the year, if it did not make it. Having enjoyed its products for its lifetime, I felt I owed the company that much. 
2. The second was the "protest vote" factor. I bought Apple in 1997 for the same reason that some Russians voted against Vlad Putin a few weeks ago in the Russian presidential election. While I saw little chance (then) that Apple would beat Microsoft, I wanted to go on record my opposition to what I saw as the Evil Empire. 
3. The third and only financial reason for buying Apple in 1997 was that the optionality that I saw in Apple. At the time, notwithstanding its troubles some of the best design people in the world were still employed by Apple and the company still had the best operating system in the world (in my biased view). If they could get their act together, I felt that they could still find a way to get back to the big leagues. It was a deep out-of-the-money option and I was open to the possibility that it would never pay off. I am glad that it did, big time, but I would attribute it more to luck than my stock picking skills. After all, I have made similar option plays every year for the last 20 years and quite a few of them did what out of the money options tend to do: end up worth nothing. (My Eastman Kodak bet did not do so well...)

Will the Apple trade change the way I invest?  I don't think so, but the lesson that I  take out of my experience is to pay more attention to the one option play I make each year. I have started my search for a company that has significant competitive advantages (that it has wasted) and is down on it luck (and price). Perhaps, I can find the next Apple in the debris...


2. A betrayal of "intrinsic value" investing
One puzzling aspect of my "sell decision" on Apple was the intrinsic valuation of the stock; at my estimate of $710/share, the stock continues to be under valued. Some of you took me to task for ignoring my intrinsic value and selling a stock at a price below that number, just because I am uncomfortable with the changing stockholder composition. I think your criticism is merited but you and I may disagree on the essence of intrinsic value. While we probably are in agreement that the intrinsic value of a firm is determined by its business acumen and operating decisions, I also believe that attracting the wrong type of stockholders to your company can reduce your intrinsic value. To back up my claim, let me start with two facts.

(a) Companies vary widely on dividend policy. 

Looking at 2011 data for US companies, for instance, here is what I see. Of the 5897 firms in my sample, 4435 paid no dividends and the distribution of dividend yields among companies that did pay dividends is captured below:

The median dividend yield among companies that pay dividends is about 2% but there is wide variation in yields across companies. (With its proposed dividends, Apple would be in the 40th percentile of dividend paying stocks in terms of yield.)

(b) Investors pick stocks based on dividend policy: Investors form dividend clienteles and buy stock in firms that have the "right" dividend policy. Thus, companies that pay no dividends tend to attract investors who care little about dividends, but have a much higher attraction for growth and price appreciation. Companies that pay high dividends attract dividend seeking investors who like price appreciation, but view dividends as the central to equity investing.  

There is a link between where companies are in the life cycle and what they pay out in dividends, with young, growth companies that face uncertain earnings and high reinvestment needs paying no dividends and mature companies that can count on earnings paying much higher dividends. If the investor make up (in terms of dividend preference) matches the company make up (in terms of where it views itself as being in the life cycle), you have stability, where firms with different dividend policies can co-exist, with little or no punishment being meted out for paying too much or too little in dividends. Each company has its own dividend clientele and tailors its investment, financing and dividend policies to keep the clientele happy.

There are three possible problem areas, where this stability can be put to the test:

1. A company/clientele mismatch: You can get mismatches at both ends of the spectrum. A young, growth company that is held by "dividend seeking" stockholders will face unrealistic demands to pay dividends, even as it runs a cash flow deficit. At the other extreme, a mature company that is held by "growth seeking" stockholders will find itself under pressure to grow, when it has few growth opportunities. 
2. A transitional company: Growth companies do transition to become mature companies and during that transition, the composition of their stockholders has to change as well. (In rare instances, you can have mature companies transition back to being growth companies...) In some cases, this change in stockholder composition happens gradually and relatively painlessly over time. In other cases, it can be tumultuous, but as the evidence of the transition mounts in the numbers (as declining growth rates, higher cash build up, more stable earnings), the "growth" seekers move on and leave the field to the "dividend" seekers.
3. A mixed clientele: It is also possible that neither the company nor its stockholders is clear about whether the company is transitioning from one phase of the life cycle to another. In many ways, this is the most dangerous of the scenarios. It is made worse, if the evidence that comes out is contradictory (higher growth and more cash build up, at the same time) because each group sees in the evidence what it wants to see, forecasts out what it would like to see and pays a price based upon its view of the future. Eventually, a day of reckoning will arrive but neither group will give up without a fight.

So, where is the link to intrinsic value? There may be none, if management is secure, resilient and makes the right calls for the company. The problem, though, is if management gets stampeded or panicked by a mismatched stockholder group into acting in ways that hurt the company's value. The managers of a mature company that is held by growth investors may seek to buy that growth at any price (by doing acquisitions or taking value destroying investments), thus lowering its intrinsic value. A company with a mixed clientele may try to keep all groups happy and reap the whirlwind. Remember Lucent, the company that AT&T created to house the research powerhouse that was Bell Labs, and then saddled with old Ma Bell stockholders who wanted Lucent to pay large dividends (a payout policy that was at war with its status as a technology company that was seeking growth). Lucent paid the dividends (to keep its dividend seeking stockholders happy), took its risky, growth investments (because it wanted to be a growth company) and paid for them with borrowed money, a toxic mix that ultimately devastated the company.

So, what does this have to do with Apple? Apple's dividend announcement could represent one of three possibilities. The first and most benign one is that Apple's managers see less growth ahead and that they are readying the company for a transition to mature company status. That will undoubtedly be a harsh surprise to those growth stockholders in Apple who continue to see another decade of innovation and profitability like the last one, but they will move on. The second and more disquieting possibility is that Apple is unsure about whether it is a growth or a maturing company right now and wants to attract both groups of stockholders.  To keep both groups happy, Apple will have to go through contortions, lurching from growth-oriented actions (announce a new product) to cashflow-oriented ones (increasing dividends). The third and most damaging possibility is that Apple instituted dividends because it felt pressure to do so, from some analysts and institutional investors, and not because of its view of the future. Think about  it. If it bends so easily to pressure when things are going well, how will it react to the ratcheting up of demands that will inevitably come, if things start to go badly? 

A battle between growth and dividend players in Apple would have had no effect on Apple three years ago, because Steve Jobs was immune from stockholder pressures (and that was both his strength and weakness). I don't see Tim Cook occupying the same position of strength. Thus, my concern is not that Apple will not react enough to investor demands but that it will become too reactive: acquiring companies it should not be (in response to the growth seekers demands), splitting its stock or increasing dividends (to keep the dividend seekers happy).

3. A return to Apple

It is possible (and maybe even likely) that I have over estimated the tensions between Apple's different stockholder groups and under estimated the resilience of Tim Cook and the current management team at Apple. The next few months will provide evidence on both fronts, as will Apple's reaction to its first big setback (which will come).  I will keep revisiting my intrinsic valuation, checking the price and looking at how Apple's management handles the pressure. I have a feeling that I will be a stockholder in Apple again one day, perhaps sooner rather than later. For the moment, though, I am in the strange position of not having any shares in Apple and being a recent addition to the  Microsoft stockholder base. I feel like I have lost my Jedi credentials and joined Darth Vader and Stormtroopers of the Empire!!!

Apple: Know when to hold 'em, know when to fold 'em..

In my last post on Apple, I made two confessions. The first was that I have loved the company’s products for almost three decades and am thus incapable of being unbiased in assessing value or marking judgments on its quality as a business. The other was that I am an Apple stockholder of long standing. At least one of these statements is no longer true, since I did sell my holdings of Apple in the last week. Since the issue of whether Apple is going to $1000/share or to $ 200/share still seems to actively debated, I wanted to explain why I chose to fold, rather than hold.

Before I list my reasons for selling, it is important that I list the justifications that I will not offer:

1. I don’t consider Apple to be over valued: I did not sell Apple because I consider it an overvalued stock. In fact, the discounted cash flow valuation that I had my last post, where I valued Apple at $710/share still holds. The only difference is that Apple, which was under valued by about 23% when I looked at it a few weeks ago (at $545/share) looks a little less under valued today (about 13% at $620/share). 
2. I don't buy the signaling stories: In the weeks since my post, Apple did decide to return a modest portion of their mammoth cash balance to stockholders, partly in a stock buyback of $10 billion and partly in the form of a regular dividend of about $10/share (which works out to a dividend of about $ 10 billion at least for this year). There are some long time Apple watchers who have viewed these actions as signals that the company no longer has the investment opportunities that it did and thus as a negative. I don’t buy this signaling story. The rate at which cash has been accumulating in Apple is evidence aplenty that they don’t have enough investment opportunities to invest this cash in. Thus, their decision to return some of that cash reinforces what is already obvious. 

So, why did I choose to sell Apple? It is because my fellow-stockholders in the company are making me a little nervous. As I look at Apple's current stockholders, here is what I see:

1. Apple has become a momentum play: Much as I would like to believe that everyone who has been jumping on the Apple bandwagon in the last year is investing for the right reason, i.e.. because they see good value in the stock, Apple has become the ultimate momentum play. In effect, the biggest reason Apple’s stock price is going up now is because it has gone up in the recent past, not because of any news stories or information coming about about the company. Don’t get me wrong. Momentum is a powerful force in markets and I had a post on the power of momentum investing strategies. As an intrinsic value investor, though, it is not only not my cup of tea but it also delinks price from intrinsic value; put differently, I don't have a competitive edge in the momentum game. 
2. Institutional favorite: Apple is now an institutional favorite, taking center place in almost every large institutional investor’s portfolio. Note that this is related to the first point, since institutional investors are creatures of momentum, buying stocks that have gone up and dumping stocks that have dropped. So, what is my problem with this? First, institutional investors are a fickle crowd, who can quickly turn on stocks that they love.... Second, as a contrarian, my instinct tells me that if institutional investors collectively think that a stock is good, it is time for me to reassess. 
3. Mixed Dividend Clientele: Apple was a momentum stock and an institutional favorite the last time I posted as well.  For me, the tipping point was Apple’s decision to institute a dividend. Can they afford it? Of course, but I think it was a tactical error at two levels. First, it represents a break from its recent and mostly successful past. For  the last 15 years, Apple has been held by stockholders who were comfortable with its policy of no dividends and high quality growth, and were willing to claim their rewards in price appreciation. By paying a dividend, Apple has opened it doors to a “dividend seeking” clientele, who not only want to see dividends paid out but want to see growth in these dividends. In fact, many of the investors who are new to Apple stock in the last few months are from this group. The clash between what the “old price appreciation” stockholders in Apple think is best and what the “new dividend” stockholders is not significant at the moment, but it will rise to the surface when things don’t go well. We are a bad earnings report or a botched new product away from a full fledged battle between these groups, with Apple's managers in the middle. Second, in my earlier post, I noted  that it would be in Apple’s best interests to put this cash issue behind them decisively by announcing a shockingly large buyback and getting back to business. In many ways, what Apple has done (in announcing a small stock buyback and a dividend) will ensure that the cash question will be a major distraction for the long term. 

Put in blunt terms, I am selling my Apple stock because I am worried about my fellow travelers in the stock. It is not that I have a problem with any of these groups individually, since I invest in other stocks where I co-exist with momentum investors, institutional investors, growth seeking investors or dividend seeking investors. In Apple, though, they are all in the mix, with different and contradictory views about what makes the company a good investment and what it should do, as a company, going forward. Each group is expecting its best case outcome: continuing price increases for the momentum group and institutional investors, high growth and a stream of new products for the price appreciation crowd and growing dividends for the dividend seekers. Perhaps, Apple can be all things to all these investors, but that is asking for a lot, and perhaps the impossible.

I bought my Apple shares in April 1997 and I have the price appreciation (and a potential tax bill) to show for it. It has been a wonderful ride, but as the old country song would put it, I have to know "when to hold 'em, know when to fold 'em”, and my gut (strange thing for an intrinsic value guy to admit to..) tells me that it is time for me to move on. Could I regret this decision? I hope I do. Nothing would make me happier than see the stock goes to new heights and have Apple become the first trillion-dollar market cap company. I love the company and its products far more than I care about any bruising my ego and pocketbook may take.

Equity Risk Premiums: The 2012 Edition

As many of you who have been reading this blog for a while know, one of my obsessions is the equity risk premium. To me, it is the "number" that drives everything we do, while investing, and two events precipitated this post. The first was an article in the Economist on the topic, arguing that investors are expecting misreading the past and expecting higher returns from equities than they should. The second was the culmination of what has now become an annual ritual for me, which is updating my paper on equity risk premiums for the fifth year (I started in September 2008). You can download the paper by clicking here. For those of you who have no time for reading long tomes, I am going to try to summarize the paper in this post.

What is the equity risk premium? 
While it is always foolhardy to talk about "one" number encapsulating the stock market, I think the equity risk premium comes closest to meeting the requirements for such a number. The equity risk premium is the "extra return" that investors collectively demand for investing their money in stocks instead of holding it in a risk less or close to risk less investment. As a consequence, it reflects both their hopes and fears about stocks, rising as the fear factor increases.

Why does the equity risk premium matter?
The equity risk premium is used by almost everyone in finance, though it is often either taken as a given or used implicitly. Thus, a portfolio manager who decides to pull out of the stock market because she feels are stocks are over priced is telling you that she thinks that equity risk premiums will increase in the future. Investors who estimate the intrinsic value of assets or stocks are making explicit judgments about the equity risk premium (when they use DCF models) or implicit judgments (when they use book value or multiples). The costs of equity and capital that firms use to decide whether to invest in a project are built on equity risk premiums, as is all discounted cash flow valuation. Legislators and pension administrators decide how much to set aside to meet future pension obligations, based upon assessments of equity risk premiums.

What determines the equity risk premium?
Since the equity risk premium (ERP is a number for the entire stock market, it is determined by the overall characteristics of the investor population and macroeconomic factors. In particular:
a. The ERP should increase as investors become more risk averse and/or prefer current consumption more.
b. As uncertainty about economic growth, inflation and other macroeconomic variables increases, the ERP will rise.
c. Since investors are dependent upon the flow of information from firms (accounting or other), the ERP will rise as information becomes less reliable or less available.
d. The fear of catastrophe always hangs over equity investments and as that fear rises, the ERP will go up as well.
Since all of these factors can change over time, you should expect the equity risk premium to vary across time as well.

How do you measure the equity risk premium?
There are three broad approaches to estimating the equity risk premium and they can yield very different values:

1. Surveys: You can ask investors or analysts what they think stocks will generate as returns in the future and net out the risk free rate from this value to get to a equity risk premium. For instance, Merrill Lynch surveys global portfolio managers and reports a survey premium of 4.08% in early 2012, i.e., portfolio managers expect stocks to earn 4.08% more than the risk free rate. A survey of CFOs by Harvey and Graham yields a 3.50% equity risk premium but another one by Fernandez yields higher numbers (5-5.5% for the US and higher values for emerging markets). I distrust survey premiums because they often represent hopes (more than expectations) and are more reflective of the past than the future.
2. Historical premium: You can look at the past and estimate the premium you would have earned investing in stocks over a risk free investment. Thus, if you look at the 1928-2011 time period for the US, you would have earned an annual compounded return of 9.23% if you had invested in stocks, over this period, but an annual return of only 5.13%, investing in treasury bonds. The difference (4.10%) would be your historical risk premium. Even with historical data, you can get different numbers using different time periods, treasury bills instead of bonds as your risk free investment, and computing an arithmetic average instead of a compounded average. The values, for the US markets, range from 7.55% (arithmetic average premium for stocks over T.Bills from 1928-2011) to -3.61% (geometric average premiums for stocks versus T.Bonds from 2002-2011). Given the volatility in stock returns, you should be wary of equity risk premiums computed with less than 40 or 50 years of data (almost always the case with emerging markets) and be skeptical even when longer periods are used (the standard error, even with the 1928-2011 data, is about 2.36%). Implicitly, no matter which of these numbers you decide to use, you are assuming that the equity risk premium for the US market has not changed in any material fashion over the last century and that they will revert back to historical norms sooner or later.  If I had to use a historical risk premium, I would go with the 4.10%, since it is long term, a compounded average and over a long term risk free rate. However, I am much more uncomfortable with the assumption of mean reversion in the US market than I used to be. since, in my view, the structural shifts that have come out of globalization have changed the rules of the game. As a consequence, I no longer use historical premiums in either valuation or corporate finance.
3. Implied premium: Just as you can compute a yield to maturity (a forward looking value) for a bond, based upon the price you pay and the expected cash flows on the bond (coupons and face value), you can compute an expected return on stocks, based upon the price you pay and the expected cash flows on stocks (dividends and buybacks). On January 1, 2012, for instance, with the S&P 500 at 1257.60, I estimated an expected return on stocks of about 7.88%, which yielded an equity risk premium of 6.01% over the treasury bond rate of 1.87% on that day. It is true that this premium is a function of my assumptions about expected cash flows in the future, but there are two reasons why I trust it more than the historical premium. First, it is forward looking since it is based upon expected cash flows in the future. Second, there is real money backing up this number, since it is based on what investors are paying for stocks today (rather than what they are saying). Third, the error on your estimate (arising from your errors on expected cash flows) will be far lower than the standard error on a historical risk premium. Given the dynamic and shifting price of risk that characterizes markets today, I think it makes sense to compute and use an updated implied equity risk premium in valuation and corporate finance.

The range of estimates we obtain for the equity risk premium from the different approaches is large but they should be judged based upon how well they perform in forecasting the future (both of equity risk premiums and actual stock returns)

Looking at the correlations, the implied equity risk premium performs best, yielding the best predictor of not only next year's equity risk premium but also of actual returns on stocks over the next decade. The historical premium performs worst, often moving in the wrong direction.

How is the equity risk premium related to risk premiums in other markets (bonds and real estate, for instance)? 
In the corporate bond market, the price of risk is measured with the default spread, i.e., the difference between the yield to maturity on a risky bond and the risk free rate at the time. Even in the real estate market, the capitalization rate operates as a measure of expected return and the difference between that rate and the risk free rate is a measure of the risk premium in real estate. In the figure below, we graph all three numbers (the implied equity risk premium, the default spread on a Baa rated bond and the cap rate premium for the US from 1980 to 2011.

Note that real estate behaves like a very different asset class in the 1980s, with the cap rate premium often in negative territory. This was the basis for the advice that many of us got in that period that investing in a house or real estate provided diversification benefits, especially if the bulk of our wealth was tied up in financial assets. Starting in the 1990s, real estate has begun to look more like a financial asset, a finding that hit home with many in the last few years, as housing prices collapsed just as stock prices and corporate bond prices declined. If these trend lines continue to hold, we may need to find a new asset class to get the benefits of diversification in the future.

It is also worth noting that when the risk premiums in the three asset classes diverge, it is a sign that one market or the other is in a bubble. Note that in early 2000, the equity risk premium dropped to almost the level of the Baa default spread, reflecting the dot com bubble. In the 2004-207 period, default spreads and the cap rat premium plummeted, relative to the ERP, reflecting the housing and credit market bubble in that period.


What is the "right" equity risk premium to use in corporate finance and valuation?
So, what is the risk risk premium to use in today's markets? The answer depends upon what you are trying to do.

1. If you are making a judgment on asset allocation, i.e., the percent of your wealth that you want to invest in equities, bonds, real estate or other asset classes, you can bring your point of view into play. Thus, if you feel that the current implied premium of 6% is too high (low) and will thus come down (go up), you should invest more (less) in equities than you normally would (given your age, cash flow needs and risk aversion).
2. If you are valuing companies or assets, you generally should stick close to the current implied premium, notwithstanding your views in the asset allocation component. The reason is simple. Using an equity risk premium that is significantly different from the current implied premium brings in a market view into your valuation and thus confounds your final conclusion. To illustrate, if you use a 4% equity risk premium to value a stock in January 2012, you are effectively assuming that the S&P 500 is undervalued by about 25%. As a consequence, if you find your stock to be cheap, based on the 4% ERP, it is not clear whether you did so because the stock is in fact cheap or because of your market views.
3. If you are a business, using the ERP to estimate your costs of equity and capital, you have a little more leeway. You can use an average implied equity risk premium over time (it has been about 5% over the last decade) in your estimation, built on the premise that there is mean reversion even in implied premiums and that your projects are long term.
4. If you are a legislator or pension fund administrator, you also have some leeway. If you do not want your contributions to the fund to be volatile, you should use the average implied equity risk premium as well.

Back to the Economist

I like the Economist, as a news magazine and as a commentator on financial issues, but I think that this article does not quite hold together. First, it starts with a premise that I investors who look at historical data are getting an estimate of the premium that is too high and that a sustainable long term expected return on stocks should be a sum of the dividend yield and the expected long term growth in dividends (which would yield a lower value). Fundamentally, I don't disagree with that notion but I think that the use of the dividend yield is far too narrow a measure of cash flow. Incorporating the additional cash that firms are generating into the yield (either by adding in buybacks or computing a potential dividend) does provide a much higher expected return for stocks. Second, it implies that using a high risk premium is an aggressive assumption, i.e., it leads to investors paying more for stocks than they should, but the opposite is true. If you demand a higher return on stocks, you will pay less for them today, thus pushing down stock prices, making it the conservative assumption to use. In fact, if we take the article's suggestion and build in a lower equity risk premium, you would be be pushing up stock prices today dramatically. 

As a general rule, I find that discussions about the equity risk premium are rife with misunderstanding about what it is, why it changes over time and how it affects investing/valuation. It would be far healthier for all concerned if analysts and investors were more explicit about why they use the equity risk premiums they do and what market views are at their basis. 

Greg Smith on Goldman: An indictment of investment banking?

Greg Smith, the Goldman VP who resigned with a searing indictment of Goldman Sachs in the New York Times, has created quite a commotion. Predictably, the responses, which are understandably heated, have fallen into two extremes. On the one side are those who are predisposed to believe the worst about investment bankers and view this as vindication for their view that investment bankers are shallow, self serving and greedy. On the other are defenders of investment banking, who argue that this article states the obvious (that investment bankers are focused on making money) and that Greg Smith is a failed, middle level banker, having a midlife crisis.

I think I have the credentials to be on either side. On the one hand, many of my best and brightest students work at investment banks (including Goldman) and I teach training programs for both incoming analysts and associates at many of the investment banks. On the other hand, I have never been shy about critiquing investment banks for creating and marketing products that add little value or for providing self serving advice to some of their clients. In fact, I begin my corporate finance class with a clear statement that the class is not an "investment banking" corporate finance class but one that is structured around how businesses (who are the potential clients of investment banks) should make decisions. And I end the class, imploring students who do go into investment banking to preserve their options to abandon, if they find themselves unhappy with the grind or uncomfortable with the consequences of their actions.

Given that I have skin on both sides of the game, I want to look at the most troubling contention in Smith's piece, which is that Goldman Sachs bankers cared little about their clients and spoke about them with contempt. (To be honest, I am not sure what to make of "muppets" as an insult... I have always liked Kermit and have nothing but respect for Miss Piggy's self reliance...) After all, it is one thing to be cast as a ruthless money machine (a critique that has often been leveled at Goldman) and an entirely different one to be accused of ripping off your clients.

Do investment banks put their interests over the interests of their clients? I would not be surprised if they do, but before you are overcome by moral indignation, I would hasten to point out the following:

1. The typical client of an investment bank is more likely to be a corporation, hedge fund or institutional investor than an individual. So what? These entities are not exactly shy about promoting their self interests and I will wager that, given a chance, they would not only exploit mistakes made by investment banks but also mistakes made by their own clients.
2. The relationship between investment banks and their clients strikes me as mutually exploitative, and neither side can exist without the other's acquiescence. Let me use one example of the disfunction that is created as a consequence. There is strong evidence that many large M&A deals are value destructive for acquiring company's stockholders. While it is true the valuations from investment banks grease the wheels for these deals, it is also true that the managers of the acquiring firms are just as much to blame as investment bankers. Intent on spending stockholder money to gratify egos and build their corporate empires, these managers are less interested in honest advice from investment banks and more so in their deal-making prowess. In fact, I think that many corporations use investment banks as shields against having to take responsibility for bad decisions, with "It was not our fault, since the investment bank told us it was okay" becoming the post-failure refrain. 

Has this always been true? It was perhaps less so, four decades ago, when investment banks were almost all partnerships and catered to clients who did not shop around and stayed with their in-house banks. Before you become too nostalgic for the old times, remember that this was just as ruthless a world, where new competition was squashed quickly and becoming an investment banker was difficult to do, if you were not born into the right family, had the right connections or went to the right school.  The "old rich" were just as greedy as the "new rich" but they did do a better job of maintaining appearances. 

Rather than invoke the past or rail against the present, I would like to pinpoint at least three reasons why investment banks have become less client focused over time:

1. Deal shopping: As Goldman gets excoriated for not being client focused, it is worth remembering that loyalty is a two-way street. In a world where clients play investment bankers off against each other, hoping to get the best deal for themselves, these same clients cannot point fingers at investment banks for playing the same game with them.
2. Specialization: I do think that finance has become too specialized in both academia and practice, with experts and traders who know everything there is to know about narrower and narrower slices of finance or securitization. As a result, the people designing and trading new financial products/services have little sense of where these products fit into the larger scheme of things, and, as a consequence, when it makes sense to use them (or not use them).
3. Compensation: I do not begrudge investment bankers their income or wealth, but I do think that investment banks have tied compensation too closely to deal making and trading success. By doing so, they have encouraged their employees to get the deal or trade done, often at a cost not only to clients but also to the investment banks in the longer term.

So, in case investment banks are interested in my advice on how to be more client focused, here is what I would suggest:

a. Hiring: Investment banks have always focused on hiring the best and the brightest and they should continue to do so. Some people, though, are better at seeing the big picture than others (think Magic Johnson on the basketball court or Joe Montana on the football field) and investment banks need to find more of these generalists to balance the specialists.

b. Incentives/ Compensation: Tie incentives and compensation more closely to maintaining long term client relationships and getting good deals/trades done. I know that this will be more difficult to do than the existing system, but it will healthier.

c. Clients/Customers: This may perhaps be the hardest part of the process, but investment bankers may need to be more picky about their customers, saying no to some, even at the expense of substantial profits. 

Not practical, you say! Well, someone has to start the ball rolling and that someone has to profitable and powerful enough to set the trend. Wait! I do have a nominee! How about Goldman Sachs? This may be the perfect time for the firm to announce a revamp of hiring and compensation structures and see if others follow. 

Apple: Thoughts on bias, value, excess cash and dividends

Apple is hitting or is close to hitting two significant landmarks. Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy.  I think it is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm.

I am biased
I have to start with a confession. It is impossible for me to be objective in my analysis of Apple and it is not just because the stock has done so well for me over the last decade. My first computer was a Mac 128K that I bought in the early 1980s and I have bought every Apple model since (even the ill fated Lisa and the not-so-great Powerbook Duo). Why should you care? One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. As you read the rest of this assessment, you should recognize that my substantial positive bias towards Apple does affect my analysis. To structure my thoughts about what Apple should do, here is how I see the choices for the company:

Is Apple's cash hurting its stockholders?
The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny:
1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors.
2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments.

So, what could be defensible reasons for worrying about cash? Here are a few:
1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits.  In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand?
My assessment: By my computation, Apple's optimal debt ratio is about 40-50% (download the spreadsheet to check it out yourself) and its current net debt ratio is -20% (using the cash balance of $ 100 billion as negative net debt). Given the risk of the business that Apple operates in, I would not let the debt ratio go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

2. The naiveté discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple.
My assessment: I would be more inclined to go along with this argument if Apple's stock price had dropped 50% over the last few years. I find it difficult to believe that after the run up that you have seen in Apple's stock price, stockholders are under valuing the company. The counter, of course, is that the PE ratio for Apple, at 16 times trailing earnings or 13-14 times forward earnings, seems low and may reflect a naiveté discount.

3. The stupidity discount: In a post on Apple more than a year ago, I referred to what I called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash.
My assessment: My personal assessment in January 2011 was that, as an Apple stockholder (which I have been for more than a decade), the company had earned my trust and that I was okay with them holding my cash. I am open to a reassessment and I think any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.


What if there is no discount?
If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, I am afraid that Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company".

Bottom line: I am inclined to believe that Apple is not being punished right now for holding on to $100 billion in cash. However, I am more concerned than I was a year ago. While I had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, I am not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, I am worried that Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, I think that it is time that we ask the follow up question: what should Apple do with all this cash?

What should Apple do with the cash?
In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take.

How about a few acquisitions? I am sure that there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away!

If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice:

1. Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors.
2. Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford. 
3. Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock.
4. Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back  shares at the inflated price hurts the stockholders who remain after the buyback. While I am normally skeptical of the capacity of management to make judgments about the "fair" value of the stock, I decided to take my best shot at valuing Apple using an intrinsic valuation model. Using what I thought were reasonable assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), I estimated a value of $716 $710 per share for Apple. You can download the spreadsheet that I used to make your own judgment. Once you have made your own estimates, please enter them in this shared Google spreadsheet. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. (Update: As many of you have rightly pointed out, a significant portion of the cash is trapped overseas and Apple will have to pay the differential tax rate (between the US marginal tax rate and the foreign tax rate already paid) when the cash is repatriated. I have added the trapped cash input into the excel spreadsheet and factored in the additional taxes.)

Closing thoughts
Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance (my guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, I would avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a  business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.

Facebook: Playing the "IPO pop" game?

In my last post on Facebook, I provided my estimate of value (about $ 70 billion) and concluded that I would not be a buyer of Facebook shares even if the company was valued at close to $ 70 billion. A few of you have taken me to task for leaving what you see as easy profits on the table, noting that if I were able to get Facebook shares at the offering price, that I would be guaranteed (or close to guaranteed) a substantial profit. More generally, there is the perception that investing in IPOs at the offering price (and making money on the offering day pop) is a low-risk, high return strategy that can be used to augment your portfolio returns. Like most "sure" things in investing, this one comes with implicit assumptions and costs and is definitely not "sure". Here is my list of caveats for those considering the "Facebook IPO Pop" strategy.

1. You have to be able to get the shares at the offering price
Let's say that when the Facebook IPO does get "priced", you bid to buy shares at the offering price. One of two things will happen: you will either get your requested number of shares or you will not, and ironically, it is the former that should worry you. If you are right in your basic hypothesis, i.e., that IPOs are under priced, the demand for the shares at the offering price will exceed the supply and the investment bankers managing the IPO will have to ration the shares. If the process is fair, you should get only a proportion of the shares you asked for, with the proportion getting smaller as the shares get more under priced. If the process is fixed and the investment banks give first dibs to their preferred customers, the proportion you get, if you are not one of the preferred customers, will be even lower. Thus, the only scenario you should dread if you are not a preferred customer is one where you get your entire allotment filled, because that is an indication that the shares are over priced.

This allotment process has always been the achilles heel of strategies that try to invest across all IPO offerings. You may bid for $100,000 worth of shares of every IPO for the next year, but you will end up with a portfolio that has too little invested in the most under priced IPOs (since you will get far fewer shares than you requested in these) and too much in the most over priced IPOs (since you will get all of the shares you asked for with these).

2. The stock has to pop on the offering date
Once you have been allotted the shares at the offering price, you have to hope for a stock price pop on the offering date. You do have history on your side. Looking across all IPOs, there is evidence of an offering day increase in stock prices. The figure below graphs out the average "under pricing" across all IPOs, by year, for US stocks:

Note, though, that this return presupposes that you can invest an equal amount in each IPO, under priced or not, but it is still impressive. Over the entire 50 year time period, there have been only four years (1962, 1973-1975) where the average returns were negative, and there are periods, such as the late 1990s, where the average return is close to 100% (doubling of price on the offering date). That is good news for the "Facebook IPO Pop" strategy.

Before you get too excited, though, note that the under pricing is greatest with the smallest offerings, as evidenced in the graph below:

Given the size of the Facebook offering (even 5% of $100 billion makes this a big offering), this graph should lead you to lower your expectations of the price pop on the offering date.

There is also evidence that this under pricing is by design. The IPO pricing cookbook at most investment banks includes a "take 15% off the value" ingredient in every pricing recipe, since the positive news stories that accompany the pop are viewed as a sales pitch for future stock issues. The under pricing also is consistent with the incentives for investment banks, who generally guarantee the offering price to the issuers, and thus have fare more to lose by over pricing than from under pricing.

This IPO under pricing has been the source of angst for some, who feel that the under pricing is unfair to the founders/owners of the company going public, since they are leaving money on the table, by offering their shares at a discounted price. That argument, though, becomes less persuasive, when you recognize that only a small portion of the outstanding shares is generally offered on the offering date. The discounted price on these shares operates the same way a loss leader operates in a retail store: it is designed to whet your appetite and get you to buy more. You hope that those who buy these shares (and feel good about the profits they make) will be back in six months or a year to buy more shares in the company. So, if you are feeling sorry for poor Mark Zuckerberg on the offering date, don't worry! There are plenty more shares in Facebook that will be hitting the market in future years.

From an investor's perspective, what can go wrong? Note that the average is across all IPOs (and is skewed by the smallest IPOs) and that a subset of IPOs see a drop in price on the offering date. These are of course the IPOs where you got all of the shares you asked for. If you are not a preferred customer, your odds of making money on IPOs decrease. Even the preferred customers are offered a mixed bag. Not only does their preference stem from the large amounts that they pay the investment banks for other services rendered, but they are expected to be "good" investors. In other words, if they flip the stock soon after the offering, it may endanger their preferred status on future IPOs. More on that in the next section!

3. You have to time your exit well
Assume now that the first two pieces of the puzzle have fallen into place. You have been allotted shares in the Facebook IPO and the stock has popped 15% on the offering date. Should you sell now or should you wait? That eternal  question has particular resonance with IPOs, because the gains on the offering date can be fleeting. Remember that Groupon's 20% jump on the offering date is now all gone!

Studies that track the post-offering performance of IPOs suggest that they do are not good investments in the aftermath. In the figure below, we compare the returns in the first five years after an initial public offering, with the returns on non-IPO stocks.

The returns on IPOs lag the returns on other stocks in the market and do so much more in the first few years after the offering. Thus, if buying at the offering price requires you to hold the stock for a year or two (which may be required of you as a preferred customer), you may not be getting a great deal.

In fact, my valuation of Facebook is predicated on the assumption that you may want to hold Facebook for more than a day in your portfolio. If you do, once the buzz fades and the IPO paparazzi leave, the company will be judged increasingly by how it performs relative to expectations. If price and value are on a collision course, value always wins out.

4. You are playing a sector and momentum game, even if you don't want to...
If you bid for shares in the Facebook IPO offering, I do believe that the odds may be in your favor for winning the game, if you define winning as getting the shares at the offering price and flipping them very quickly after the IPO. Much as I am tempted to join you, I am afraid I will sit out that game and not because of any noble impulses (such as wanting to be a long term investor or not speculating).

The IPO game is a subset of the momentum game, on which I have posted before. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers. To see the link, note that IPOs go through hot and cold phases, with years in which you have hundreds of IPOs and years in which you have a few dozen.

In addition, also note that IPOs in any given year tend to be concentrated in a few sectors and those sectors generally have momentum on their side (dot com stocks in the 1990s, social media companies today). Thus, the success of IPOs in a sector is closely tied to whether the sector maintains it "hot" status.

One worrisome aspect of IPOs is that they may operate as canaries in the coal mine in signaling momentum shifts; the loss of enthusiasm for dot com IPOs (and the withdrawals of some) coincided with the epic collapse of the sector that year. The momentum driving social media companies will end one day and it may very well be the day that Facebook goes public. "Unlikely", you say, and I agree, but the tough part of being a lemming is that you never know where the cliff is coming. Of course, you may be able to sense momentum change much better than I, in which case you should be able to play the game successfully.

Bottom line
A strategy of investing in IPOs at the offering price looks much better on paper than it works in practice. All of the academic studies that show the average underpricing are implicitly based upon the assumption that you can create an equally weighted portfolio of all IPOs, when in fact, a non-discriminating investor will end up  will be with too much invested in all of the worst IPOs.

The strategy can be made to work by an investor who uses analysis (valuation or information) to invest only in IPOs that are most likely to be under priced and follows through with timely selling to capture profits after the offering. Even for that investor, it is a supplementary strategy since there will extended periods where there are no or very few IPOs in the market.

So, if you are bidding for those Facebook shares, good luck. I hope you get only a fraction of the shares you ask for (see part 1 for why), that the stock price pops on the offering date, that you get out before the you-know-what hits the fan. and that you are not the unfortunate soul who helps ring in the end of the social media circus.

Finding Finance as a Solo Entrepreneur

Finding finance as a small business or a lone entrepreneur can be very challenging to say the least. Although most governments todayrealise that the success of theor economies can be greatly enhanced by supporting small businesses more and providing a good breeding ground for entrepreneurs with viable business plans to start up, few of them will be willing to take on the banks with regulation to force more small business finance and loans.

But have you wondered why there are so many claims that the banks have shut up shop? Surely they can only make money by lending money. It simply makes no sense at all for them to stop lending completely.

The evidence is that they are still lending – at around R500 million each month in new term loans to businesses turning over less than R1 million. In total, the banks have about R37 billion of term loans outstanding to small businesses and around R7 billion of overdraft lending.

Of course figures can hide more than they tell you. Some numbers seem to say that, on average, small businesses are borrowing less and saving more, which could support the banks’ argument: that they cannot lend because small businesses do not want to borrow. But the answer must be more complicated than that or small firms would not be complaining.

To me, it seems that there are businesses that:
 • • Have enough cash to save some away and don’t need to borrow.
 • • Want to borrow and do get loans from the banks.
 • • Could borrow to invest, but choose not to just now.
 • • Might borrow but think they will be turned down.
 • • Want to borrow and don’t get a loan from their bank.
 It’s the last group that potentially causes the most concern. The most pressing cases are always when a business is on the brink. It may need to pay wages or a key supplier but a customer has not paid or, worse, has gone bust or gone elsewhere. So, even if the business is profitable, the cash isn’t there to pay the bills. The obvious first call is to the bank – can I have or extend an overdraft?
Well, while the bank will want to lend, it won’t want to lose money, so it needs to be satisfied that the business can repay the loan or pay down an overdraft.

It needs to be sure that there will be enough cash not only to repay, but also to provide a buffer in case other customers go down or disappear. And with the current state of the economy, the banks have probably been looking for bigger buffers.

Even if you show you can repay, the bank will often need some more comfort. It still needs to get its money back if the repayments aren’t made, so it asks for security as well.

That can make it very difficult to borrow. Even if you are profitable, think you can afford to repay, and have some assets, the bank might still say NO! Why? Well remember that the money being lent is often the savings of other people and other businesses: so it can’t afford to take risks with that.
But are the banks being too risk averse? The truth is that nobody knows the answer to that question because nobody can know with any certainty how quickly the economy will be back to sustainable growth and how rapid that growth will be. Only when confidence returns will banks feel able to relax their lending criteria. In other words, when the sun comes out!

So what can be done? If the banks don’t meet the targets government has set, growth will be slower and less certain, creating a vicious circle.

But it’s not just about targets; there is practical help for lending as well. Where a bank would lend but can’t because of a lack of security, it can call on the Government’s Enterprise Finance Guarantee (EFG). The scheme can substitute for a lack of, or even absence of security, and it can be used for new borrowing, restructuring existing borrowing, overdraft extensions or invoice finance facilities. It helps the bank to say Yes where otherwise it would say No.

There is plenty of capacity available for banks to use it and as much support as they need to help them do so. There is no reason for them not to. They’ve already used it to help over 15,000 businesses borrow more than R1.5 billion.

Not only does the EFG help businesses who would otherwise be turned down, it can also encourage those that think they may be turned down to make an approach to their bank. That can encourage investment and help to get the wheels turning again. Just what we need.

One final interesting statistic which questions the mood of gloom. Tucked away in the latest insolvency statistics is the news that the liquidation rate of companies in the year to end-June was 0.7 per cent.

That’s the proportion of active companies that went into liquidation in the year. That figure is much lower than the peak of 2.7 per cent in 1993 and lower than the 25 year average of 1.3 per cent. So perhaps things aren’t so bad in the real economy?

As a lone entrepreneur part of the challnge of starting up succesfully will surely t gain access to the business finance you need. In South Africa today companies like the IDC and SEDA is doing their bit to ensure that previously disadvantaged have the business finance support they need. Companies like Business Plan Whiz will provide you with direct access to investors when you are creating your business plan and Investors Network will introduce you to business investors at regular networking events for strart-ups. But the facs is that much more still needs to be done in order to esnure that this most crucial