Thursday, January 31, 2013

Apple and Amazon

Over the past couple of weeks both Apple and reported results that did not meet the expectations of the Wall Street community.

However, while Apple's stock cratered - and now looks poised to retrace its entire 2012 gains - Amazon's stock jumped higher despite revenue numbers that were more than $1 billion lower than Street estimates.

I have written on previous occasions that I am totally at sea when it comes to analyzing Amazon as an investment.  While I am a huge fan of the company - most of the Glen family holiday purchases came by way of - I don't understand why it there are so many buyers of a stock that is trading at 161x earnings.

(Apple's P/E multiple, meanwhile, is less than 10x).

Writing on his blog The Reformed Broker, Joshua Brown wrote a piece on Amazon aptly titled "Amazon. com:  Defying Logic and Physics Since 1997". He quoted extensively from another blogger Tyler Durden of Zero Hedge about the company.

Here's the excerpt from Durden:

The most cartoonish stock of all time just came out with results that can only be characterized as WTF. To wit:
  • Q4 revenue of $21.27 billion missed expectations of $22.23 billion
  • Q1 EPS of $0.21 missed expectations of $0.27;
  • The firm guided top-line lower, seeing Q1 sales of $15-$16 billion, below the estimate of $16.5 billion
  • The firm guided operating income much lower, seeing Q1 op income of ($285)-$65 Million on expectations of $261.4 MM
  • The firm said the its physical books sales had the lowest growth in 17 years
  • Total employees grew by 7,000 in the quarter and 32,200 Y/Y to a record 88,400
  • Worldwide net sales Y/Y growth was the slowest in years at 23%, down from 30% in Q3 and 34% a year ago
  • And, last and certainly least, LTM Net Income is now officially negative, or ($49) meaning as of this moment the firm with the idiotically high PE has an even more idiotic N/M PE.
... And the stock is soaring in the after hours. Thank you DE Shaw, or actually that is Mr. Bezos who should thank you for the latest AH favor where accelerated HFT buying creates the impression that the numbers were good. They weren't.

However, former Merrill Lynch tech analyst Henry Blodget wrote a piece on Business Insider which captures why he believes continues to defy the naysayers.  Henry has been following the company for years.
The bullish Amazon story is this:
  • Amazon is the global leader in a massive market, ecommerce, and it has become so synonymous with "online shopping" that many consumers now just start their searches at
  • eCommerce has a huge barrier to entry: The distribution systems, scale, and technology that Amazon has built over the last 15 years make it hard for anyone else to sustainably offer comparable prices and service
  • Amazon's revenue growth is very rapid for a company of this size (although it has begun to decelerate)
  • Amazon has made massive investments in the past few years in fulfillment, the Kindle (and, probably, smartphones), and Amazon Web Services. These investments have depressed Amazon's earnings--and they are about to start paying off
  • Amazon's results were better than Wall Street's expectations in one key way--profit margin.
  • Amazon's profit margin is low and increasing
This last point is the critical one:

Some sophisticated investors believe that Amazon's profit margin will increase rapidly over the next couple of years. This, in turn, is expected to drive earnings growth that is far faster than revenue growth.

Specifically, Amazon's earnings per share are expected to skyrocket from basically $0.00 in 2012 to about $5.00 in 2014. And that expected profit growth, which is expected to be driven by Amazon's expanding profit margin, has investors jazzed.

Blodget goes on to write that while he gets the bull case for Amazon, he still has trouble accepting the company's current valuation in the market.

So do I.

Tuesday, January 29, 2013

The Ghosts of 1994

At the beginning of 1994 I was one of the most popular bond managers in the country.

Twenty years ago I was the manager of the AARP GNMA and US Treasury fund.  Endorsed by AARP, but marketed by my firm Scudder, Stevens & Clark, I was managing one of seven different mutual funds offered to AARP members.
1994 moment
Source: Bloomberg; BusinessInsider
As the decade of the 1990's began, the Fed had moved interest rates steadily lower in order to keep economic growth moving.  With inflation at bay, the Fed felt that it had some room to keep monetary policy easy.

However, low interest rates penalized savers and investors, particularly those who were retired and living on fixed incomes.

The appeal of the higher rates offered by the AARP GNMA fund - as well as the fact that GNMA mortgage-backed securities were backed by the full faith and credit of the U. S. government - was like catnip to yield-starved investors.

So the money poured in.   While I don't remember the exact figures, I do remember that it was not unusual for the fund to receive $20 million in a single day - pretty heady stuff.  Although I would have liked to believe that it was solely due to my skillful management ability, I knew that it was the appeal of high interest rates from a portfolio of government guaranteed securities that was the real draw.

By the end of 1993 the AARP GNMA fund was not only the largest of the funds offered to AARP members, but it was also one of the largest bond funds in the country.

However, in 1994 Alan Greenspan and the Fed began to worry about inflation.  Early in the year they began to raise short term interest rates, and interest rates across the maturity spectrum soared.

Bond prices - which move in the opposite direction of interest rates - plummeted, taking the net asset value of bond mutual funds down with them.  I had been managing the AARP GNMA fund in a conservative fashion, but it didn't matter - the share price of the fund began a year-long decline.

Shareholders freaked out.  They had invested in the fund to obtain more income, but they apparently had not realized that bond prices could fall as well as rise (even though our prospectus clearly spelled out the risks).  Large redemptions started coming in, and I was forced to sell bonds to give investors their money back.

As the chart above shows, yields on 10-year Treasurys started the year around 5.75%, but by the late fall of 1994 rates had climbed over 8%.  This meant capital losses for nearly all bond holders.

Ironically, in 1995, rates retraced most of the rise which had occurred in the prior year. But no matter - shareholders who had left did not return.

Thus ended my period of popularity as a bond fund manager.

1994 has been on the minds of many investors these days.  Today the Fed is promoting a very easy monetary policy to spur economic growth.  But the day is coming that policy will change, and interest rates will rise.

Bond funds have been extremely popular in the past few years.  Similar to the period in the early 1990's, ultra low short term interest rates have forced investors to look for alternatives.

According to Michael Hartnett at Merrill Lynch, more than $800 billion has flowed into bond mutual funds since 2006.  In the same time period, nearly $600 billion has moved out of equity funds.

But when rates start to rise, how will investors in bond mutual funds react?

According to Morgan Stanley's Huw Van Steenis, this was the single biggest question being asked at Davos last week.  Here's what the blog Business Insider
wrote yesterday:

The consensus of much of the official sector and investors at Davos was that central banks have maxed out and should be soon start focusing on exit, given the unprecedented size of this experiment and its impact on asset prices. 

Every single long-term asset owner I met, and numerous longer-term investors, voiced concern about asset prices and the risks from a huge knock from rates backing up (a super-sized version of 1994). While so far one can argue that the monetary injection was vital to offset massive deleveraging, it is clear that the risks for debasement of currencies remain high.

Monday, January 28, 2013

Is Procter and Garmble Now A Growth Stock?

One of my most popular posts last year was titled "Has Procter & Gamble Turned Into A Utility?"

Written on June 22, 2012, the piece noted that for the last 10 years P&G returns and price movements had closely matched the returns for the utility sector. But perhaps the overall negative outlook that the share price of P&G at the time reflected an opportunity.

Here's what I wrote (I added the emphasis today):

For the 10 year period ending in June 2002, P&G stock returned +250%, or more than +50% than the broader market averages.  Not surprising, P&G was among the most widely held stocks in institutional as well as individual portfolios.
The last decade has been different, however.  P&G has struggled to maintain its earlier growth rates. Although its stock price has kept up with the broader market averages, P&G's stock has lagged many of its competitors, and some are wondering whether the company has simply become too big to be anything more than a market performer.

But still:  Where there is skepticism there is opportunity.

I don't know whether P&G will ever return to its former self.  However, for investors starving for yield in this era of financial repression, the stock might not be a bad place to hide.

Let's start with the dividend yield.  P&G sports a 3.8% dividend yield which is almost certainly safe. The company has one of the strongest balance sheets in Corporate America (AA rated by the rating agencies) and its businesses are not particularly capital-intensive.

By comparison, utility stocks have been a favorite among investors looking for yield. As a group, utilities pay a dividend yield of 3.9% (I am using the utility exchange-traded fund - ticker XLU - for comparison).

The valuation of P&G and XLU are nearly identical:  15x trailing 12 months earnings. No one is particularly excited about the growth prospects for either, so valuation is also a draw.

But here's where I think that P&G comes out more favorably than utilities:  The relative valuation of utility stocks versus the S&P is at its historic high.  The group trades at a +20% premium to the market which seems to be to be pretty aggressive given the nature of the utility business.

P&G, on the other hand, is trading below its historic valuation versus the broader market over the past 10 years.  True, it traded lower - in 2009 - but for the most part investors were historically willing to pay a higher premium for P&G's combination of high dividends and consistent (albeit slowing) business results.

The chart I have posted above suggests that if we are truly in a low market growth envir
onment - which seems likely - that high dividend, low expectation stocks like P&G are worth a look.

Last week P&G reported earnings last week that were ahead of Wall Street's expectations, and the stock jumped. 

Since  I wrote my piece last summer, the stock is up +22%.

The point of mentioning all of this is not necessarily to call attention to my good call last summer (well, not totally) but rather as a way of showing that even boring consumer staples stocks can be attractive when sentiment gets too negative.

So what about now?  Is P&G's run over?

Well, I must confess I am less excited about the stock than I was last summer. If nothing else the stock today is trading at 21x trailing 12-month earnings, so it can hardly be considered cheap.

But the skepticism about the company still remains.  Here's what the Financial Times wrote over the weekend:

That is why P&G's improved outlook is, ultimately, a disappointment.  The company expects 1-2 per cent sales growth (after losing a couple of percentage points to currency effects).  On the bottom line, earnings per share growth is targeted at 3-6 per cent.  Given that about 2 percentage points of that EPS growth will come from share buybacks, one can only wonder when the cost-cutting that management has often promised will lead to meaningful operating leverage. Maybe {an} index fund is the way to go, after all.