Growth – at what cost?

I recently ran into someone who commented on the past year in the market.  We are just back to where we were a year ago, he commented.  I decided to look at what has actually transpired in the markets’ perception of what to pay for assets in varying economic scenarios.  To do so, I decided to look at one of the best run companies.

Research in Motion (RIM) is a company that we all know and many of us use its products daily.  It is a true success story from its inception to the ubiquity of its products in our lives.  Its vision has changed the way in which we operate and has enabled business to be more connected, thereby offering a very valuable service to everyone.  I cannot comment strongly enough on the magnitude of its impact.  When I think of truly great and visionary companies, this one easily comes to mind.  And, even better, it is a Canadian company.  That’s about the company, now about the stock.

The stock today is around $70.  At its bottom it was $50 and at its recent peak was $90.  So we are almost exactly half way between the 2 points.  My view is always that at these extreme points in time the stock prices are arbitrary figures and only represent what investors believe is the outlook at that exact point in time.  The real value of a company is much more difficult to measure but what most use is a multiple of the returns it produces for its shareholders in terms of growth in assets, earnings and shareholder’s equity.  In Rim’s case there are 573 million shares outstanding and every trading day a value is put on the company by the price per share paid and multiplying this by the number of shares outstanding to get the market capitalization.   We will look at the valuations at these pivotal moments in time:   the 2008 high; the March 2009 bottom and a recent peak in September 2009 as well as today.

But before that, let’s discuss some quantitative attributes of RIM, the company.  The company is large with a phenomenal balance sheet, no debt and around $2bn in cash (that’s around $3.50 per share).  It has high profitability, high returns to shareholders and strong growth.  These are attributes that any investor should gladly pay for.  In summary, it is a truly great company.  But at what price?

Today Research in Motion is valued at C$42bn.  (all figures are approximate and in Canadian $).  It is valued at 3 times sales of $14b and 18x earnings of $4.00   Rim is a truly exceptional company in my view – it has a very high return on equity (28%) and grows around 25% per year.  Its net margin is 17%, which would put it at the top of companies in terms of profitability.  As well, it has a great balance sheet.   Truly phenomenal and there is no debate about this.

At its peak in March 2008 the stock market valued the company at $86bn.  At that time it had $6bn a year in sales (now it has more than $3bn a quarter in sales!) making the price to sales ratio at a whopping 14x.  The p/E or the price the market was wiling to pay for $1 of earnings was 66x or $66 for each $1.  The rest of the financial metrics were similar to today – cash on the balance sheet was the same, there was no debt, etc.   One year later in  March 2009  (at the market bottom) RIM was valued at just $29bn down 66%,  a price to sales of just 2x  and a p/e of 15x.  It still had all the other things mentioned above – high profitability and high growth.   But the market wouldn’t pay much for that because it couldn’t see forward and know what RIM was going to earn.  Visibility was unclear – would anyone ever buy another blackberry?  No visibility = uncertainty, something no one is willing to pay for.

At its recent peak on September 23^rd,    RIM was trading at C$90 and had a market value of $52bn.  The market was willing to pay 4x sales and a p/e of 22.5x.  ROE was just as high and earnings growth was still at 25% and the balance sheet, as always, was superb.

So, what has happened since then?  Well, expectations have clearly changed.   They were high for the quarterly results and investors were disappointed.  If you read the most recent quarterly statement it actually reads almost word for word to many of the previous ones:  “the breakdown of sales was 81% devices.... New subscribers totalled 3.8million.  Cash was $2.5bn. Revenues were up 27%“    all sounds very good.   So what has changed from September 23^rd, just 12 days ago?

Today, RIM’s value (as determined by the stock market) is $40bn.  Its p/e is 17.5x and its growth is still 25%.  It is stuck in no man’s land between very expensive (March 2008) and very cheap (March 2009).  It is cheap but not very cheap.  A bit like the whole market.  We know what we are buying; we just don’t know what we should pay for it.  We know it’s not cheap but we don’t know what the correct price is; there are just too many pieces to the puzzle that are missing, for example, what is the sustainable growth rate for sales and earnings.  We cannot know the answer to this, what we do know is that this company is a phenomenal machine.

90% off but is it a bargain?

A few days ago I was in a store and I discovered to my delight, a 90% off rack.  I have never in my lifetime seen such a thing and I was very excited at the prospect of finding a bargain.  I kept stopping people to point it out but they, unlike me,  were no longer surprised by the high level of discounting – the store was filled with 70% and 80% off racks and 90% to them was just another number. I finally found someone to comment on it, a salesperson.  I told her “I have never seen a 90% off rack”.  She replied “ yes, it’s just this one and we’re losing a fortune on these items.”. All the better for me, I thought like the big bad wolf.   I looked them over and noted the decline in prices – one jacket had started its life at $1695, then was marked down to $1019, again at $999, then $699 and finally rested at $499.  With 90% off, it was now selling for $49.90 a total markdown of 97%! 

As I stood in line to try on these bargains,  a lady in the line made a comment that I would like to explore:  “ but what was the markup originally?” she asked when I commented on my surprise at 90% off. 

This got me thinking about mark-ups and mark downs and pricing in general and how it applies to the markets (and jackets).  In this case,  the markup really didn’t matter because there was no way this jacket cost $50 to make, ship and store in the retail outlet.  The fabric, sewing and design would have gobbled up at least the $50 current price.  Shipping, sorting and inventory costs would have added to that number even in an optimistic environment.  I figure the minmum this jacket could have cost all in was $100-$150.  So, at its peak of $1695, the markup was huge, if my calculations are anywhere on the ball.

But that is the problem.  I don’t actually know what the jacket  cost to make and I don’t know how far off the mark the original price was.   So we get back to where we always get to – price is a function of what someone is willing to pay at the time for the item in question.

The stock market over the past few years is very similar to this jacket.  It had a huge markup.  Everything was booming and when it came down , in many cases, stocks dropped 50-75%.  Earlier this year, people were, on average, not willing to pay anything for assets even though they were on the sale racks. They just didn’t want them.  In March, when all the pessimists were calling for the final meltdown, I figure the S&P was trading at around 8x the reduced earnings outlook for the next year.  But, like the jacket’s cost, I can’t know for sure.  In the past, the low on the market valuation has been  at 6.6x with hindsight.  Of course, at the time of the exact low we don’t know the price of the earnings, and can only guess what the earnings may be under a variety of scenarios.  It is only with hindsight that we can see that the market usually bottoms around 6.6x historically.  The two things we don’t know at the time are the earnings and the price we should pay for them.  And, that’s basically everything we need to know!  Since that is everything we need to know  to buy the market, we don’t buy it.   At the time,  like the shoppers in my store, we figure 90% off isn’t such a great deal.  But stocks are not wasting assets like a jacket in a store. They are growth assets and become more valuable over time especially with inflation and we must remember this.

So, I am going to  go out on a limb:  I would like to state that I know for sure  that the earnings for 2009  will be very bad .  And, I believe the price we will eventually pay for them will be around the 6.6x level or in the vicinity.  The big question is when.

But let me finish this blog with the piece de resistance.  I was so happy with my 90% off purchase that I actually returned to the same store get more unbelievable bargains (greedy consumer that I am).   When I got back into the store, not only had the 90% off rack disappeared as well as the 80% rack but the exact same jacket that I had purchased for $49 was now priced at $350 just 3 days later!

I would like to make one comment about this story:  it is infinitely easier to price something like a jacket than intangibles such as stocks, bonds or other financial assets.  But even with a tangible item that can more easily valued,  I noticed a certain psychological argument going on in my head:

• If this jacket is worth so much, why hasn’t anyone else grabbed it?
• What if I am paying too much?  (crazy but I did think it)
• What if it goes down further in price?  I might get a discount of 99%, for example.
• Is it really worth $49?

Although all these thoughts sound completely crazy in hindsight and in view of the immediate increase in price of the jacket, I really did think these things as I was waiting in line.  The comment by the lady in line, shook my confidence in my judgment severely as I considered the possibility that the real value of the jacket was something I could not really pin down and it could actually be worthless and only a fool would buy it. 

There are many lessons in this life experience.  One is that we never really know for sure everything about the things we are buying and we may not even know the really important things enough to make a proper judgment but when something is down 90% and you can use it, it’s probably a bargain.  Second, is that psychology plays the biggest part in buying bargains and this makes it doubly hard to go against the crowd at these times.   But, truly great investors, do just that.  

To Motor or to not motor – what will happen to GM and the US auto industry?

Five years ago ( March 2003) I was lucky enough to attend the Geneva Auto show.  I saw presentations from all the major auto manufacturers and the economy, although somewhat weak at the time, was staged for a rally to new growth.  I remember noting the commotion surrounding the GM presentation as I was sitting at the back of the room.  Most companies had 1 or 2 representative in attendance for their presentations. When it was GM’s turn, it was like watching an Asian create jobs task force.  At least a dozen executives arrive (most likely all in private jets, no doubt).  I remember clearly marking on a piece of paper that GM would be bankrupt in 5 years due to a very large outstanding pension fund obligation of $40bn but at the same time they expected quarterly earnings of $2.00 per share in the interim.  I expected that that pension fund time bomb would be dealt with over the next 5 years and I was always shocked when GM stock rose, if only for a short time.  I knew some who made money on the short term trade.  When GM hit a 50 year low earlier this year, despite all I knew, I was shocked.  I had never seen a stock hit a 50 year low.  The market cap is now at an incredible level of   1.2% of sales. 

I have spent many years studying turnaround companies and have found that when there are no earnings or major structural issues, price to sales is the best ratio to use, providing debt levels are taken into consideration.  Companies losing money generally trade below sales usually at 50%.    If the industry or company appears to be in long term decline,  the ratio can drop to 10% of sales or lower.  Apple (most will not believe this now) was trading at 10% of sales in 1997.  Now it trades at 4-5x sales, a remarkable recovery considering how much their sales have grown but it was teetering on bankruptcy at the time and things have improved dramatically since then.  The food retailers in the US were trading at 10% of sales in 2003 when they were being attacked from all sides by competition. They have since recovered to 30% of sales and are now doing well having adapted to their new environment.  It was clearly a buying opportunity for an industry in the midst of change.  The auto industry price to sales ratios show how dire the outlook for their companies is perceived at this time:     GM at 1.2% of sales,  Ford  at 5.6% of sales (this is after having tripled recently) , BMW at 21% of sales and the star of the industry is the mighty Porsche at over 100% of sales (remember they also make money in short squeezing the hedge funds).

Of course, GM sales are expected to decline and earnings are a figment of the future.  The great debt loads and future obligations will tax this company into the foreseeable future. Without structural change or dramatic restructuring of the obligations, there is really no hope for this company.  Of course, in bankruptcy it can continue indefinitely operating producing cars which lose money but it is hard to be optimistic about the US car industry without it shedding its burdens of high cost production and long term obligations to its workers as well as an overstaffed and paid executive staff.  Dramatic changes are required and will be painful.  Then there is also the issue of when Chinese cars arrive on the market.  We have not even begun to think of the implications of this future which is not far away.  Japanese production is a mere fraction of what Chinese companies will produce once their car industry is up and running.

The US needs to reduce its dependency on manufacturing in view of the threat from China.  The UK lost its auto industry in the 1970’s.  The US needs to lose its industry as well, at least in the way it is set up today.  A new model must be employed that is leaner, more targeted and much smaller.   It is unfortunate, but inevitable.  Like the steel industry of the early 1980s and the airline industry of the 1990s, the model of growth without focus is obsolete and outdated.  It will need to change to reflect the new reality of a world dominated by Asia and its prowess of low costs, innovation and marketing dynamics. 

What will happen to all the unsold cars?  Where will they store them? For more than a year in Toronto, one has been able to drive past Downsview fields to see car after car parked there.  Left outside in the extreme climates of Toronto, who will want these vehicles?  This all needs to be worked out before the American auto manufacturers can move forward.

The fact remains:  there is too much capacity in the US car industry and in the car industry worldwide. This capacity relates directly to the steel industry and indirectly to everything that goes into cars.  That means that industrial capacity must contract globally and that is what we are going through. Producing cars for the sake of keeping jobs is not an option going forward.  Capacity must be taken out of the industry to get it back to health.  The world does not need 2 French car firms, 3 US car firms and numerous Japanese ones as the Chinese and Indians enter the market with more efficient and cheaper cars.  It needs products that provide customers with a sense of what they want.

For those of us who are old enough, we have seen it all before. Chrysler went bankrupt several times before being bought by Ceberus recently and may still go bankrupt a 3^rd time.    I am reminded of a song from the late 1970’s and here are the lyrics which could be deemed almost repetitive now, actually it’s really interesting to note how many parallels there are from the late 1970s to now.  We have seen it all before and will see it all again before it is over.

I'm Changing My Name to Chrysler

by Tom Paxton

Oh the price of gold is rising out of sight

And the dollar is in sorry shape tonight

What the dollar used to get us

Now won't buy a head of lettuce

No the economic forecast isn't right

But amidst the clouds I spot a shining ray

I can even glimpse a new and better way

And I've demised a plan of action

Worked it down to the last fraction

And I'm going into action here today

CHORUS:

I am changing my name to Chrysler

I am going down to Washington D.C.

I will tell some power broker

What they did for Iacocca

Will be perfectly acceptable to me

I am changing my name to Chrysler

I am headed for that great receiving line

So when they hand a million grand out

I'll be standing with my hand out

Yes sire I'll get mine

When my creditors are screaming for their dough

I'll be proud to tell them all where they can all go

They won't have to scream and holler

They'll be paid to the last dollar

Where the endless streams of money seem to flow

I'll be glad to tell them what they can do

It's a matter of a simple form or two

It's not just renumeration it's a liberal education

Ain't you kind of glad that I'm in debt to you

Since the first amphibians crawled out of the slime

We've been struggling in an unrelenting climb

We were hardly up and walking before money started talking

And it's sad that failure is an awful crime

Well it's been that way for a millenium or two

But now it seems that there's a different point of view

If you're a corporate titanic and your failure is gigantic

Down to congress there's a safety net for you

©1980 Accabonac Music (ASCAP)

Into Thin Air:  the Property Bubble

There has been much talk about the property bubble in the US and its eventual bursting.  I have a different take on the whole credit crisis.   Rather than blame the crisis on derivatives I simply believe that prices are too high and there is too much speculation. Due to a long protracted period of lower than necessary interest rates we have speculation in the property market like never before.

Here in Toronto, a wannabe world class city of 4 million people, the 4 Seasons recently announced the launching of a residential/hotel complex to be completed some time in 2011.  The Four Seasons has a top quality cache name, evidenced by the sale of the total company last year for a phenomenal price.  The location is on the outskirts of Yorkville- not the best but not the worst location, in my view.  I would rate it a B location.  Suites in the residential section sold for $1,000 a square foot on the opening bid, $2.5m for a 2500 square foot apartment with around $200,000 down and another couple of  $300,000 deposits on contract completion for a total investment  of around $1m (all figures are In C$).  At the time, that was the top price/square foot ever for condos in Toronto and it is around 50% higher than properties that have ground under them, i.e. residential houses.  These condos sold out rather quickly.  That same apartment just 6 months later was priced at $3.25m or $1,300 (May 2007).  Now the market for the same size apartment is $4.25m or $1,700 a square foot., just 3 months later, an increase of 29%.  Remember no real money has changed hands or will for some time and the building will not even begin construction for some time.   The actual return on investment has been, too put it mildly, phenomenal.   As well in a very short period of time considering what little was required in terms of capital.  However, owners cannot sell on their properties until nearer to completion, so it remains unrealized.  Of course, from what I am hearing, many of the buyers are foreigners and many from China/HK.

What we must remember is this is for AIR.  The property has not started to be built and will not be completed for four years. 

But few find this extraordinary in these heady days of property speculation.

In the Sunday New York Times this weekend I checked out the property supplement to see what $1,700 per square foot buys you around the world.   Almost everywhere has prices quite a bit lower than that, with the obvious exceptions: London, Paris and Moscow.    I found only one comparison with such a lofty price:  ironically a loft in Tribeca, a trendy neighbourhood in New York.   It has always been Toronto’s ambition to have New York prices, so I guess something has been achieved. 

I certainly hope that the prices are real because it makes my property worth a whole lot more but I suspect that it is just speculation and the real thing will be somewhat less than the fantasy when the reality arrives.

And that is my conclusion:  the real problem is not the sub prime, not the derivatives but purely speculation, phenomena that has been a part of human nature since the beginning of time.  Even Alan Greenspan concedes that bubbles are a part of life:  “I am coming to the conclusion that bubbles are inevitable.  Human beings cannot avoid them….  They cannot learn” he is recently quoted as saying. 

How does speculation generally work its way out?    Through a reduction in prices and a reduction in volume is the usual result.    Eventually speculators lick their wounds and go home.  We are currently seeing the early stages of the process right now.  Greed has yet to turn to fear.  Once it does we will see the prices of assets reduced to a more normal level.   Remember all those profits have been firmly implanted in peoples’ minds even though not yet realized.  Making money won’t be so easy for speculators in the future as their profits turn into thin air.

In December 1900, a group of forward looking people put together a list of predictions for the year 2000.  The list has 29 entries  in all; some are quite amusing.   In case you’re interested, it can be found at:

http://www.yorktownhistory.org/homepages/1900_predictions.htm

Here is my favorite excerpt from the Ladies Home Journal, December 1900:

Prediction #20: Coal will not be used for heating or cooking. It will be scarce, but not entirely exhausted. The earth’s hard coal will last until the year 2050 or 2100; its soft-coal mines until 2200 or 2300. Meanwhile both kinds of coal will have become more and more expensive. Man will have found electricity manufactured by waterpower to be much cheaper. Every river or creek with any suitable fall will be equipped with water-motors, turning dynamos, making electricity. Along the seacoast will be numerous reservoirs continually filled by waves and tides washing in. Out of these the water will be constantly falling over revolving wheels. All of our restless waters, fresh and salt, will thus be harnessed to do the work which Niagara is doing today: making electricity for heat, light and fuel.

Reading the list of the other predictions certainly makes one think about how different things were back in 1900.  Coal polluted the land and people couldn’t open the windows on trains for fear of breathing in the foul air.  People cooked with coal and used it to heat their homes causing soot and dirt to be everywhere (sort of like China today!).   It is hard to imagine just how horrible coal made life at the turn of the last century.    We are certainly better off today as coal is used primarily only to fire turbines supplying the electricity directly into our homes as well as acting as an agent in steel making, both far removed from us.   As to whether coal is scarce or will run out in the year 2050, it’s anyone’s guess.  Of course, coal is not very popular right now, certainly not as popular as nuclear because of the Green Machine.  When I mentioned coal to someone recently, they exclaimed:  No one wants that anymore!   And, as predicted in 1900, this is very true.

Metallurgical coal is used in making steel and occurs only in specific areas of North America and Australia.  It is, in a sense, scarce.  However, with the drive towards cleaner alternatives, the whole coal group has been ignored.  Recently, demand and prices have been picking up and supply is limited.  It is one of the few resources where this can be plainly seen and predicted.   Some are forecasting prices to rise by 33% in 2008 and that’s after a 29% price increase in 2007.  This is due to a decline in exports from China, now  a net importer of coal for the first time.

Coal stocks are cheap.  They trade on low multiples and some have high yields (Fording has a 7.6% yield). They have not been caught up in any of the other mining frenzies like moly and uranium.  (Perhaps someone will launch a coal fund in the future?)

Earlier this year there have been rumors that some Indian companies are interested in acquiring coal companies in Canada.   This rumor moved first one stock, then another.  Because their stocks are cheap, it is a likely scenario.  Indian companies are becoming more acquisitive and like to buy companies cheaply.

What are the risks:  Coal companies are hostage to the vagaries of weather, in particular with regard to the transportation of their product.  There is only one rail line and this can limit their ability to ship.  Coal prices are also a risk, and the Chinese don’t always play fair in this market, as in others.  

The Chinese market has been running hard and has been called a bubble by many including some Chinese politicians.  I once tried bubble tea, a favorite at the Chinese markets.  It is so  sickly sweet that suddenly you don’t want any more.  That’s what the Chinese market is like right now. Sickly sweet, sometime soon, we may not want it anymore.

The market is charging at a pace that is unsustainable: moving up around 1% per day for the several months, 82% to date,  after a whopping 130% last year.  The press reports:

Much analysis has been written about what’s going on in China but I find that there are really only a few things one needs to know.

1.                  The Chinese market is closed to foreigners;

2.                  The Chinese love to gamble;

3.                  Liquidity is booming, and real rates are zero or negative in China;

4.                  There is limited supply of equity in the Chinese market.

From looking at these 3 factors, I can only come to one conclusion: 

the Chinese bubble will likely be the biggest bubble we have ever seen.

I read somewhere that 50% of the trading volume in China is suspected to be government corporations who may have to be bailed out, if they have losses.  I guess that’s ok because the Chinese governmentt has a lot of money. and it is unlikely that they’ve had any losses with such a rising market.

Let’s look at what happens with a rapidly rising market.  It is like a big appetite, it needs more and more:  more volume, more price increases, more news, more and more investors. 

Now let’s look at what we know about China right now:

1.                  It is undergoing an industrial revolution the likes of which we have never seen before in our lifetimes

2.                  Economic growth is more than 10% per year

3.                  Inflation is picking up

4.                  Asset prices are skyrocketing

5.                  there are shortages of everything

6.                  quality is an issue.

What do I think will happen?

Emerging markets gather steam and momentum over time finding more and more investors in their upward moves.  China has been no exception.  I was remembering the first time I heard about Chinese demand for metals in the late 1980’s.  It took more than 12 years for the result to be actually realized.  In the mid 1990’s when I was running emerging money, manufacturing in China was a distant future.  People were still talking about places like Madagascar and Malaysia.  Then China hit the market and all bets changed. 

I recently watched the film, Manufactured Landscapes.  It was interesting because it filmed a very large factory in China.  Panning the factory took the first 10 minutes of the film.   I noted very little activity from the workers.   Quality controls are also a problem with Chinese goods. We have seen both Chinese pet food and Chinese drugs having poisonous consequences, now we are faced with unsafe toys.

A few weeks ago I read in the paper about the discovery of a factory which had slaves and children working  in 2 provinces in China.  The workers apparently had been beaten, starved and forced to work for long hours for no pay.  One was beaten to death.  The owner rather than apologizing for his opportunistic behavior stated blankly:  “I feel this was not such a big issue, just a matter of beating and cursing workers and not paying wages to them” he was quoted in the newspaper as saying. 

The lack of outrage by consumers is surprising to me but it may be coming.  Sticking my neck out, I believe that we are at the tipping point of a consumer backlash against Chinese goods.  The tide has turned and those who can, will choose goods made elsewhere and may even pay a higher price.  We are also at the tipping point of the market.  It is only a matter of time before people wake up and see the risk they have been taking and decide it’s been too much.  The Chinese market has continued upward while the subprime crisis occurs in the US.  This is not logical.  Americans are the biggest consumers of Chinese goods.  Plus, the economic growth in China is likely to subside somewhat with the winding down of the boom for the Olympics next year.  When we look back, it is likely we have seen the peak of economic growth at 12%.  Expect cracks to appear as the marginal flow of excess capital peaks.