Tag Archives: portfolio-strategy

SAT Investing

Can investors learn something from the SATs? It may be only a few more days to Christmas, but it’s also college application season. A lot of high-school seniors are filling out the Common App, writing and re-writing essays, and anxiously awaiting their latest test scores. And there’s a test-taking technique that kids use to improve how they do on standardized tests that can help investors. It’s elimination. When they come to a question to which they don’t know the answer, they can improve their scores by eliminating what is most clearly wrong. In a multiple-choice test, someone just filling in the circles gets 20 or 25% correct by random chance. But by eliminating the obviously wrong answers, students can better their odds. They won’t guess right every time, but they’ll do better than if they had left the answer blank. In the same way, investors can do better by eliminating what’s wrong. If a company’s business model makes no sense – if you can’t figure out how they earn their money – then don’t own that business. If management seems to be focused more on politics and celebrity than capital investment and HR, don’t buy the stock. This is a variant of The Loser’s Game by Charlie Ellis. We can be smart by avoiding dumb ideas. For example, in December of 2000, Enron employed 20,000 people and claimed revenues of over $100 billion. But some analysts started looking in depth at their derivative books and couldn’t figure out how the company was earning all their money. There was a gap between what was reported and what they could confirm. We know how this story ends: Enron filed for bankruptcy in December 2001. The executives used a willful, systematic, and intricately planned accounting fraud to inflate their earnings. (click to enlarge) Enron stock. Source: Bloomberg Investors would have improved their relative performance by avoiding Enron. That was difficult to do: the company was a media darling, considered a high-flying harbinger of the new economy. It had tremendous price momentum. But it was hard to see how they could turn 2% growth in utility revenues into consistent double-digit earnings growth for themselves. By looking under the hood – understanding the business, reading the financials – investors can sometimes avoid the big flops. And just like when kids take the SATs, if you can improve your odds – in a low-return world – that just might be enough.

Thoughts On Metrics And Incentives

Thoughts on Metrics and Incentives first appeared at The Activist Investor. A brief meditation on motivating, measuring, and rewarding executive performance. Metrics have been in the news lately: Sensational accounts of how share repurchases boost EPS to benefit CEOs Bennett Stewart promoting his Corporate Performance Index (CPI) Corporations futzing with GAAP accounting, specifically EBITDA, to present great results. Let’s consider the metric alphabet soup, then. EPS: Earnings per Share, duh. Accounting profit divided by number of outstanding shares. EBBS: Earnings Before Bad Stuff. EPS without expenses that management doesn’t like, the zenith of futzing. EBITDA: Earnings Before Interest, Tax, Depreciation, and Amortization. A customary measure of operating cash flow, but based on accounting profit. Adjusted EBITDA: see EBBS, call it AEBITDA ROI: Return on Investment, with whatever measure of return and investment the company chooses. Highly futz-able. TSR: Total Shareholder Return. Change in share price, plus any cash to shareholders as dividends. Can’t really futz with it. CPI: Corporate Performance Index. The new metric, based on EVA (Economic Value Added). How to make sense of all this in the context of recent news accounts? For as long as investors have monitored EPS and EBITDA, companies have tried to massage it into EBBS or AEBITDA. GAAP accounting is rife with judgment, so management will seek to influence (futz with) EPS and EBITDA in subtle ways, or just dispense with it and use EBBS and AEBITDA. Investors also know that EPS measures mostly the returns part of ROI. We also want to know the investment part. Bennett Stewart years ago gave voice to these two concerns with EVA. It deals with the two problems of EPS, EBBS, EBITDA, and AEBITDA: management can futz with accounting results, and thinks capital investment comes free of charge. He spent decades trying to persuade companies and investors that EVA improves on these other metrics. We don’t know why Stewart created CPI, which starts with EVA. It seems like he wanted something similar to but better than TSR in exec comp packages. Many exec comp packages reward EPS or change in EPS. Lately, they also reward TSR. Neither idea makes any sense. Basic economics, and indeed cognitive and behavioral science, finds that one designs incentives to elicit the behavior one desires, or to discourage behavior one doesn’t. In this instance, exec comp incentives should pertain directly to decisions and other actions that executives can influence and control. Executives don’t influence and control share price. TSR measures mostly share price. On the other hand, executives control the metrics EPS, EBBS, EBITDA, and AEBITDA, in addition to controlling the decisions and other actions whose outcomes these metrics measure. That won’t work. More generally, exec comp programs should use metrics that measure company performance, not investment performance. TSR makes sense for a PM, but not for a CEO. EVA or maybe CPI makes sense for a CEO. EPS makes no sense for anyone. Critics can object to share repurchases that boost exec comp. Let’s improve exec comp and the underlying metrics – reward and punish CEO decisions and other actions, and make it hard to futz with the metrics. Leave share repurchases alone.

Focus On Less Leveraged Companies When The Markets Get Squirley

By Eric Bush, CFA, Gavekal Capital Blog 2015 is looking like one of those years in the stock market where it feels like investors have wasted a lot of time and effort for nothing. We have undoubtedly had a lot of ups and downs, both literally with stock prices and emotionally for investors, and all we have gotten in return is a market that is basically flat (intraday, the S&P 500 is a whopping 48 bps higher YTD). We all know that even in a flat market, however, there are pockets of the market that have done well (i.e., growth counter-cyclicals ) and that have performed poorly (hello to energy stocks and to our friendly neighbor to the north ). For investors who think a more volatile market is here to stay for 2016, it may be helpful to focus their attention on companies with less leverage. This strategy paid off in 2015. In the scatter plot below, we plot median YTD performance (y-axis) against median long-term debt (LTD) as a % of total capital. We are looking at industry groups for both emerging market and developed market companies. As you can see, companies with lower overall levels of long-term debt as a percentage of its total capital tended to have higher equity returns this year. In fact, if we look at equity returns over the past four years, we see that this relationship continues to hold. We would be surprised if in 2016 more liquid companies didn’t continue to dominate their more leveraged peers. (click to enlarge) (click to enlarge) (click to enlarge) Disclosure: None.