Monday, March 22, 2004

The Hidden Risk in “Religion” Stocks

March 22, 2004 - Street Insight A basic property of religion is that the believer takes a leap of faith: to believe without expecting proof. Often you find this property of religion in other, unexpected places – for example, in the stock market. It takes a while for a company to develop a “religious” following: only a few high-quality, well-respected companies with long track records ever become worshipped by millions of investors. My partner, Michael Conn, calls these “religion stocks.” The stock has to make a lot of shareholders happy for a long period of time to form this psychological link. The stories (which are often true) of relatives or friends buying few hundred shares of the company and becoming millionaires have to fester a while for a stock to become a religion. Little by little, the past success of the company turns into an absolute – and eternal -- truth. Investors’ belief becomes set: the past success paints a clear picture of the future. Gradually, investors turn from cautious shareholders into loud cheerleaders. Management is praised as visionary. The stock becomes a one-decision stock: buy. This euphoria is not created overnight. It takes a long time to build it, and a lot of healthy pessimists have to become converted into believers before a stock becomes a “religion.” Once a stock is lifted up to “religion” status, beware: Logic is out the window. Analysts start using T-bills to discount the company’s cash flows in order to justify extraordinary valuations. Why, they ask, would you use any other discount rate if there is no risk? When a T-bill doesn’t do the trick, suddenly new and “more appropriate” valuation metrics are discovered. Other investors don’t even try to justify the valuation – the stock did well for me in the past, why would it stop working in the future? Faith has taken over the stock. Fundamentals became a casualty of “stock religion.” These stocks are widely held. The common perception is that they are not risky. The general public loves these companies because they can relate to the companies’ brands. A dying husband would tell his wife, “Never sell _______ (fill in the blank with the company name).” Whenever a problem surfaces at a “religion stock,” it is brushed away with the comment that “it’s not like the company is going to go out of business.” True, a “religion stock” company is a solid leader in almost every market segment where it competes and the company’s products carry a strong brand name. However, one should always remember to distinguish between good companies and good stocks. Coca-Cola is a classic example of a “religion stock.” There are very few companies that have delivered such consistent performance for so long and have such a strong international brand name as Coca-Cola. It is hard not to admire the company. But admiration of Coca-Cola achieved an unbelievable level in the late nineties. In the ten years leading up to 1999, Coca-Cola grew earnings at 14.5% a year, very impressive for a 103-year-old company. It had very little debt, great cash flow and a top-tier management. This admiration came at a steep price: Coca-Cola commanded a P/E of 47.5. That P/E was 2.7 times the market P/E. Even after T-bills could no longer justify Coke’s valuation, analysts started to price “hidden” assets – Coke’s worldwide brand. No money manager ever got fired for owning Coca-Cola. The company may not have had a lot of business risk. But in 1999, the high valuation was pricing in expectations that were impossible for any mature company to meet. “The future ain't what it used to be" – Yogi Berra never lets us down. Success over a prolonged period of time brings a problem to any company – the law of large numbers. Enormous domestic and international market share, combined with maturity of the soft drink market, has made it very difficult for Coca-Cola to grow earnings and sales at rates comparable to the pre-1999 years. In the past five years, earnings and sales have grown 2.5% and 1.5% respectively. After Roberto C. Goizueta’s death, Coke struggled to find a good replacement -- which it acutely needed. Old age and arthritis eventually catch up with “religion stocks.” No company can grow at a fast pace forever. Growth in earnings and sales eventually decelerates. That leads to a gradual deflation of the “religion” premium. For Coke, the descent from its “religious” status resulted in a drop of nearly 20% in the share price – versus an increase of 65% in the broad market over the same time. And at current prices, the stock still is not cheap by any means. It trades at 25 times December 2004 earnings, despite expectations for sales growth in the mid single digits and EPS growth in the low double digits. It takes a while for the religion premium to be totally deflated because faith is a very strong emotion. A lot of frustration with sub-par performance has to come to the surface. Disappointment chips away at faith one day at a time. “Religion” stocks are not safe stocks. The leap of faith and perception of safety come at a large cost: the hidden risk of reduction in the “religion premium.” The risk is hidden because it never showed itself in the past. “Religion” stocks by definition have had an incredibly consistent track record. Risk was rarely observed. However, this hidden risk is unique because it is not a question of if it will show up but a question of when. It is very hard to predict how far the premium will inflate before it deflates – but it will deflate eventually. When it does, the damage to the portfolio can be huge. Religion stocks generally have a disproportionate weight in portfolios because they are never sold -- exposing the trying-to-be-cautious investor to even greater risks. Coca-Cola is not alone in this exclusive club. General Electric, Gillette, Berkshire Hathaway are all proud members of the “religion stock” club as well. Past members would include: Polaroid – bankrupt; Eastman Kodak -- in a major restructuring; AT&T – struggling to keep its head above water. That stock is down from over $80 in 1999 to $18 today. Emotions have no place in investing. Faith, love, hate, and disgust should be left for other aspects of our life. More often than not, emotions guide us to do the opposite of what we need to do to be successful. Investors need to be agnostic towards “religion stocks.” The comfort and false sense of certainty that those stocks bring to the portfolio come at a huge cost: prolonged underperformance.
Vitaliy N. Katsenelson, CFA
Copyright 2004

Thursday, March 04, 2004

Attitude is Everything

March 4, 2004 - Street Insight Paraphrasing Yogi Berra, investment is 90% mental -- the other half is skill. The right emotional state of mind is critical since investing is not an exact science. An ability to make rational decisions under uncertainty with incomplete information is what investing is all about.
Our investment process starts with asking the questions that put us in an "investor state of mind." By that, I mean we focus our thought processes on deciding whether to make an investment in the company. We're not trying to make a speculative trade in the stock. The first questions we ask ourselves when we look at a stock are: Do we want to be in this business? If we do, at what price? Very often investors look at the company's financial statements, at ratios, at the stock price and forget that there is a business with products and people behind those numbers. By buying a stock, we are hiring company's management to run a business for us. We have to like the company's business to buy the stock, no matter how cheap the stock is.
We prefer to own businesses that consistently grow revenues, have predictable earnings and generate healthy free cash flow. This means that we avoid deep cyclicals. Their revenues and earnings are unpredictable, and their capital intensiveness tends to cause sub-par free cash flow. Another question that we ask ourselves is: Would we feel comfortable buying the stock if the stock market was closed for a couple of years and we could not sell the stock? This question addresses the issue of sustainable competitive advantage.
A couple of months ago, my partner, Michael Conn, and I were discussing Hewlett Packard (NYSE: HPQ). The stock was beaten down and looked cheap. When we asked ourselves the question, "Would we own this stock for years?" the decision not to own HP became very clear. HP is a mature company that produces commodity-like products with constantly declining prices (servers and PCs). HPQ's main competitor, Dell, has a much lower cost structure (which is key in a commodity business) and is eyeing HPQ's cash-generating gravy train: printers. In these circumstances -- declining prices and the entrance of a lower-cost competitor -- we could not comfortably own HP for very long. It might be a good trade, but we are not traders.
In our mind, long-term investing is more than just holding stocks for a "long" period of time. Let us not confuse investors with stock collectors. Long-term investing is an attitude, a state of mind. The liquidity of the stock market often lures investors to become traders. We don't pay a lot of attention to everyday rants in the stock market. We look for opportunities that are created by that noise.
We love it when investors over-penalize a company for a short-term snafu and create a buying opportunity; or become overly optimistic and push the stock (of the company we own) to a ridiculous valuation, allowing us to unload the shares to a greater fool.
We try to find inefficiencies in the market that are created by the difference in investment time horizon between us and most mutual funds. Mutual funds focus (with few exceptions) on outperforming their peers (and corresponding indices) in the current quarter. Fund inflows and outflows are driven by the fund's latest quarterly performance. A stock that stands in the way of short-term performance gets dumped as a curse, giving us a chance to buy it on the cheap.
A good example of us buying a fine company on a short-term stumble in the stock price is our purchase of insurance broker A.J. Gallagher (NYSE: AJG) last year. AJG's management took advantage of a competitor's weakness and hired away over a hundred sales reps. That calculated decision caused a decline in gross margins and lower earnings per share (EPS) growth for a year and half -- exactly the time it takes for a sales rep to become profitable. Management made a conscious decision to sacrifice short-term EPS for long-term growth. The company's long-term fundamentals improved, but the stock declined from 35 to 25.
We look at a couple of dozen new stocks a year, but very few meet our stringent criteria. The ones that we find to be good companies but overvalued stocks we put on our watch list and patiently wait for opportunity to present themselves. We love it when a good company stumbles -- that is when our fundamental analysis comes in handy. If the stumble is short-term in nature, then we buy it with both hands. Disclosure: position in AJG Copyright 2004