Oh, no! Apple is in trouble again!
Apple's recent growth in its new portable electronic gadget's sales seem to go misunderstood by a certain segment of observers. Just today, we get another nitwit wondering if Steve Jobs can "save" the iPod from destruction by the iPhone. Let me spell this out: if Steve Jobs could move iPod buyers en masse to the iPhone, he'd dance all the way to the bank. Oh, yeah.
Don't throw me into the briar patch!
Back to Basics
The iPhone sells for more than an iPod. Atop the sticker price, Apple receives subsidy payments from carrier partners. The margins on iPhones are incredible. The iPhone also enables Apple to tap users over time for application sales, and to show them something about life on MacOS X, which powers both the phone and Apple's line of desktop and notebook computers.
Moving a buyer from a lower-priced, lower-profit product to a product that is costlier, has higher margins, and enables additional related revenues over time has a name: upselling.
When Apple engages in upselling of customers from music players to the handheld computers it markets as multifunction telephones, however, there's some fraction of people who weep for the "lost" sales of cheaper products Apple might have sold the customer. This is like crying for a Honda dealer who pulls off an Acura sale. Do you think local dealers would rather sell their customers a Toyota, or a Lexus? What do you think Toyota itself prefers? (Note: Lexus is a Toyota brand, made by Toyota, like iPhones are an Apple product. There's no competitor here, it's an upsell situation.)
The truth is that Apple's strategy of offering products at a great range of price points isn't a suicide pact, and doesn't for any reason compel Apple to have enormous sales volume at any given price point. Apple's pricing strategy is intended to ensure that every customer can see an Apple music product at the price they want to pay so they will enter the store, where Apple can upsell them. The fact that some of them really only want an iPod Shuffle for the gym on a given day is no problem for Apple: the iPod Shuffle isn't really competition for the iPhone. It is competition for competitors who want to hook customers on proprietary file formats that might make it hard to later become Apple customers, though, and Apple stands guard against it with its own online store and its own line of players.
So far, Apple seems to be doing pretty well with this.
As the iPhone gains capabilities, the overlap between customers for the iPhone and Apple's other products will increase. Sure, the iPod Touch is a direct competitor for folks who didn't want the phone on their handheld. However, the iPod's 80GB storage attracts some folks who don't see the iPhones' 8-GB or 16-GB storage as offering a plausible substitute. That gap will close, and as it does the iPhone will attract more and more of the iPod's former buyers.
This works to Apple's benefit: iPhones generate more revenue for Apple.
On the other hand, as iPods march downward in price, they crush the hopes of competitors who want a piece of the large and growing portable music player market. Apple does better making a $99 sale to some distant music lover in a foreign land than it does keeping all its products at $200 and higher. The brand-building exercise Apple is running with in the music business is likely to continue paying dividends as long as Apple keeps the user experience good with whatever product Apple provides.
Why we have to keep hearing about iPhones hurting Apple by eating into iPod sales when the math works in the other direction -- that upselling benefits Apple -- is a result of two colliding trends. First, Western media aren't paid to be accurate, but to be viewed -- which is how advertisement revenue is built. So-called news outlets aren't making their money on truth but on sellers of products and services who pay 'news' outlets to show you ads while you read their thoughtless drivel. Second, alarmist disaster news is attention-getting, which (a) reinforces the eyeball count so important to the ad sales, and (b) makes good FUD.
Showing posts with label reporters. Show all posts
Showing posts with label reporters. Show all posts
Thursday, September 4, 2008
Thursday, August 28, 2008
'Big Lie' Alive And Well In Post-Soviet Russia
The theory of the Big Lie is deceptively simple: if your story is so outrageous that nobody would make it up, people will buy it.
Take the story related by a Soviet émigré about his first time entering a grocery store in the West. When he spotted the aisle with the condiments, it didn't take long for him to end up his knees, weeping.
Buy, why, you ask?
In the Soviet Union, it was hard to obtain mustard. The reason had been clear for years: a worldwide mustard famine deprived the world of access, and only good Soviet planning made available the tiny amount that was to be had. If you weren't a Party official, though, you could pretty much plan to do without. It'd all been in the news for years, and the empty Soviet shelves bore the story out year after year.
Seeing one grocery store's condiment aisle packed with row after row of mustard containers, all different flavors -- he counted dozens of different brands of mustard before he broke down -- he realized that if his government was willing to lie about mustard then ... what might it not have lied about?
So, what's the news now? Putin says the United States orchestrated the violence in Georgia to manipulate November election results, though he's not saying in favor of which candidate, or even displaying any evidence of American involvement.
The story is crazy for a number of reasons, not the least of which is Occam's Razor.
Occams Razor is the principle that the explanation that requires positing the fewest causes is the superior explanation. To accept Putin's proposed scheme, we need to accept (1) a U.S. desire to make war within a country that seemed poised to acquire NATO membership, (2) Georgian complicity with a U.S. military scheme -- a scheme so quiet that nobody's leaked it or evidence of it in either involved government or on the field of battle -- and (3) Russian zeal to protect its helpless allies in an autonomous zone recognized by Russia as autonomous only after it invaded. To accept the alternative that suggests itself, we need only accept Putin believes what he himself proclaimed: that the break-up of the Soviet Union was the greatest tragedy of the twentieth century. Believing this, it's clear Putin would rather Russia invade Georgia before, rather than after, admission to NATO. Once you believe this, Putin's story falls nicely into the historical context of the Big Lie tradition long-exercised by the Soviet Union as a propaganda tool.
Will it fail this time? Russia offers the crazy story both for his own domestic consumption (where it could succeed nicely), for consumption by those inclined to latch onto anti-U.S. stories of all colors wherever they are generated and however implausible simply because they are eager to repeat anti-U.S. claims, and for consumption by United States voters who will receive good FUD tending to make voters nervous about the peaceful intentions of anyone even slightly tending to be labeled a hawk. The fact that most people don't buy it doesn't mean it won't have meaningful impact at the margins.
The Big Lie is definitely a solid basis for FUD for the masses.
The interesting thing about propagandizing the West is that for-profit media doesn't have a special bias toward viewpoints that are accurate. The bias in Western media is toward viewpoints that alarm people, and will keep eyeballs glued to the set long enough to show another commercial. Lying to the West is cheap, particularly if you are a high-profile personality followed by reporters precisely to get headline stories to sell.
Take the story related by a Soviet émigré about his first time entering a grocery store in the West. When he spotted the aisle with the condiments, it didn't take long for him to end up his knees, weeping.
Buy, why, you ask?
In the Soviet Union, it was hard to obtain mustard. The reason had been clear for years: a worldwide mustard famine deprived the world of access, and only good Soviet planning made available the tiny amount that was to be had. If you weren't a Party official, though, you could pretty much plan to do without. It'd all been in the news for years, and the empty Soviet shelves bore the story out year after year.
Seeing one grocery store's condiment aisle packed with row after row of mustard containers, all different flavors -- he counted dozens of different brands of mustard before he broke down -- he realized that if his government was willing to lie about mustard then ... what might it not have lied about?
So, what's the news now? Putin says the United States orchestrated the violence in Georgia to manipulate November election results, though he's not saying in favor of which candidate, or even displaying any evidence of American involvement.
The story is crazy for a number of reasons, not the least of which is Occam's Razor.
Occams Razor is the principle that the explanation that requires positing the fewest causes is the superior explanation. To accept Putin's proposed scheme, we need to accept (1) a U.S. desire to make war within a country that seemed poised to acquire NATO membership, (2) Georgian complicity with a U.S. military scheme -- a scheme so quiet that nobody's leaked it or evidence of it in either involved government or on the field of battle -- and (3) Russian zeal to protect its helpless allies in an autonomous zone recognized by Russia as autonomous only after it invaded. To accept the alternative that suggests itself, we need only accept Putin believes what he himself proclaimed: that the break-up of the Soviet Union was the greatest tragedy of the twentieth century. Believing this, it's clear Putin would rather Russia invade Georgia before, rather than after, admission to NATO. Once you believe this, Putin's story falls nicely into the historical context of the Big Lie tradition long-exercised by the Soviet Union as a propaganda tool.
Will it fail this time? Russia offers the crazy story both for his own domestic consumption (where it could succeed nicely), for consumption by those inclined to latch onto anti-U.S. stories of all colors wherever they are generated and however implausible simply because they are eager to repeat anti-U.S. claims, and for consumption by United States voters who will receive good FUD tending to make voters nervous about the peaceful intentions of anyone even slightly tending to be labeled a hawk. The fact that most people don't buy it doesn't mean it won't have meaningful impact at the margins.
The Big Lie is definitely a solid basis for FUD for the masses.
The interesting thing about propagandizing the West is that for-profit media doesn't have a special bias toward viewpoints that are accurate. The bias in Western media is toward viewpoints that alarm people, and will keep eyeballs glued to the set long enough to show another commercial. Lying to the West is cheap, particularly if you are a high-profile personality followed by reporters precisely to get headline stories to sell.
Sunday, July 6, 2008
On Non-Analysts
This post at Seeking Alpha offers unusual quality: instead of vacuous pretend analysis, it offers readers links to some non-Analysts whose analysis of Apple whose depth and thoughtfulness isn't matched among typical analytic output.
Why should this be surprising? The best minds in investment houses aren't occupied drafting investment analysis for retail investors, they're occupied making money. By contrast, retail investors who have a serious stake in the companies they follow have both time and incentive to develop a more complete picture of the companies they follow -- based not only on the work of other analysts, but based on observation and on comparisons and models that may have yet to reach the attention of busy analysts. If these private parties have the inclination to discuss their thinking, they can be great sources of thought on the companies followed.
The highlighted non-Analysts include Andy Zacky, author of the Bullish Cross blog. His analysis looks at historical trends to project earnings relative to recent company guidance. He shows his math in tables that are easy to follow, and he offers support to some specific predictions from sources that report on computer sales. Perhaps the most delightful example of how observant, reasonable people can get better results than analysts signing their names above well-recognized firm logos, is offered by this Zacky paragraph:
Another non-Analyst highlighted by the above-linked article goes by the handle Deagol on MacObserver's Apple Financial Board, and has posted analytic spreadsheets on StashBox. A strength of Deagol's comments is that he doesn't preach buying or selling in general, but in comparison to specific prices, based on his fair value calculations. A downside is that he seems to be modeling from past trends and without reference to specific current-product market-performance issues. His recent spreadhseet makes an interesting argument that analyst earnings estimates are of little predictive value of Apple performance, but that share price tends to predict the company's future earnings at a specific PE. How to interpret this in light of the shares' volatility is presumably left as an exercise for the reader. It might be interesting to see these results plotted backward further into the past.
Of course, my own analysis of Apple has certainly shown some shortcomings -- but at least where I've posted views I've been consistent with my story. Revising my historic predictions on the basis of earnings announcements isn't a game the small-timers and amateurs can play -- they'd be laughed out of the ballpark. We've got to make sense.
Paid analysts don't even need to make sense.
Why should this be surprising? The best minds in investment houses aren't occupied drafting investment analysis for retail investors, they're occupied making money. By contrast, retail investors who have a serious stake in the companies they follow have both time and incentive to develop a more complete picture of the companies they follow -- based not only on the work of other analysts, but based on observation and on comparisons and models that may have yet to reach the attention of busy analysts. If these private parties have the inclination to discuss their thinking, they can be great sources of thought on the companies followed.
The highlighted non-Analysts include Andy Zacky, author of the Bullish Cross blog. His analysis looks at historical trends to project earnings relative to recent company guidance. He shows his math in tables that are easy to follow, and he offers support to some specific predictions from sources that report on computer sales. Perhaps the most delightful example of how observant, reasonable people can get better results than analysts signing their names above well-recognized firm logos, is offered by this Zacky paragraph:
iPhone estimates are relatively easy and straight forward and easy to calculate this quarter. As of the end of fiscal Q2 2008, Apple sold approximately 5,407,000 iPhones as indicated by Apple's financial statements. On June 9, 2008, approximately 21 days before the end of the quarter, Apple's own Steve Jobs announced at WWDC 2008 that Apple has sold 6 million iPhones as of that date. Simple math indicates that Apple will sell approximately 600,000 iPhones for Q3 — 5.4 million Apple already sold as of the end of Q2 minus the 6 million iPhones announced at WWDC amounts to 600,000 iPhones. Since Apple has discontinued the current model, and announced the new 3G model, I doubt the EDGE iPhone will be making significant inroads between June 9 and June 30 which marks the end of the fiscal quarter. As easy as this calculation sounds, you'll be surprised to see how many analysts will get this wrong.Zacky's upside estimate, modeling the event that Apple's recent gross margin drop was a temporary matter, provides an idea what magnitude the possible upside surprises might be.
via Bullcross.blogspot.com
Another non-Analyst highlighted by the above-linked article goes by the handle Deagol on MacObserver's Apple Financial Board, and has posted analytic spreadsheets on StashBox. A strength of Deagol's comments is that he doesn't preach buying or selling in general, but in comparison to specific prices, based on his fair value calculations. A downside is that he seems to be modeling from past trends and without reference to specific current-product market-performance issues. His recent spreadhseet makes an interesting argument that analyst earnings estimates are of little predictive value of Apple performance, but that share price tends to predict the company's future earnings at a specific PE. How to interpret this in light of the shares' volatility is presumably left as an exercise for the reader. It might be interesting to see these results plotted backward further into the past.
Of course, my own analysis of Apple has certainly shown some shortcomings -- but at least where I've posted views I've been consistent with my story. Revising my historic predictions on the basis of earnings announcements isn't a game the small-timers and amateurs can play -- they'd be laughed out of the ballpark. We've got to make sense.
Paid analysts don't even need to make sense.
Monday, June 30, 2008
Brit Chick Puzzled Over Drunk College Girls
This article -- a product of the Times, no less -- answers the very question it pretends to ponder, without apparently noticing.
The question:
Predators don't need to outrun the fastest prey to make a kill -- just the slowest. That's the enormous benefit of being a predator: you can fail again and again and still hunt. Staking out the watering hole doesn't hurt their odds.
The fact that something like 97% (of a series of 148 slightly-trained women who fought male attackers) succeeded suggests that men who assault women aren't looking to enter and win a fight, they're looking for a good victim. The lesson should be relatively straightforward: don't bend over backward becoming a conspicuously more helpless victim.
The question:
It was once the preserve of the rugby team, but now female students down more units than boys. Why is the fairer sex drinking so much?The author seems to find the drinking an irony, rather than an inevitable result, of some facts she's gathered:
Unfortunately for the fairer sex, science is against us when it comes to coping with alcohol.... The combination of our size, enzymes and extra fatty tissue seemingly adds up to a less efficient system for breaking down the booze.The answer is right in her article:
A survey conducted by the Portman Group in 2005 found that over a third of women surveyed had been sexually assaulted whilst drunk. Almost the same number of women asked had also had unprotected sex after drinking. The latest medical research shows that this number has now almost doubled and unwanted pregnancies and STI’s are a more frequent consequence.Just to spell it out: Free frathouse booze + naïve fools who think the guys at a university can't be as bad as Dad warned them ==> herds of does, getting slower and more defenseless three times faster than the frat boys operating the keg handles.
Predators don't need to outrun the fastest prey to make a kill -- just the slowest. That's the enormous benefit of being a predator: you can fail again and again and still hunt. Staking out the watering hole doesn't hurt their odds.
The fact that something like 97% (of a series of 148 slightly-trained women who fought male attackers) succeeded suggests that men who assault women aren't looking to enter and win a fight, they're looking for a good victim. The lesson should be relatively straightforward: don't bend over backward becoming a conspicuously more helpless victim.
Friday, June 20, 2008
Professional Stock Analyst Opinions: Thumbs Down
I have to admit that I really enjoy Jim Cramer.
Jim Cramer is utterly unafraid to take a strong position. Whether it's to buy Sears (SHLD) at 180 or -- as just recently -- to sell American Capital Strategies (ACAS) at under 28, there's little reason ever to think Mr. Cramer is soft-pedaling his opinion. Not that Cramer is married to his analysis; after preaching the virtues of Sears as a working-man's hedge fund and the turnaround genius of Eddie Lampert in a video touting Sears as one of a series of stocks likely to become Berkshire Hathaway-style single-share retirement funds, Cramer posted about SHLD that folks could short it. And there, I suppose, is the take-home lesson: the folks who get interviewed to opine on stocks aren't in front of the camera because they're right, but because they're entertaining.
That we have a media environment that is based on entertainment rather than truth is something with some interesting and far-reaching consequences as consumers, including as investors. More on that in a later post -- it's a big deal. The main application here is that the story that's easiest to find is probably easy to find because it's exciting, not because it's the most accurate. Excitement means clicks, links, eyeballs, and ad revenue. Truth -- well, who knows whether it's true? But we can tell pretty quickly if it's entertaining. You don't have to be Warren Buffett or Socrates to notice who keeps you on the edge of your seat when they talk.
So let's -- you know, just for fun -- have a look at Cramer's recent thumbs-down on American Capital:
Let's look at the business for a moment. American Capital Strategies Ltd. has developed three profit streams. And let me be clear: these aren't just revenue streams, or business plans, they're honest-to-goodness, proven profit streams. Allow me to spell this out for those who haven't heard it. Since going public in 1997 at a price of $15 per share, ACAS has paid over $25 in dividends, and last quarter had a GAAP net asset value of over $28 per share[1]. I understand that in the wake of Enron and WorldCom there's a certain amount of skepticism regarding accounting practices and valuations, and I'll ignore for the moment the serious problems applying these concerns to this particular company's assets -- but you can't restate dividends you've actually paid. Those are paid already. While the shares have vacillated between trading above net asset value and trading below net asset value (which spurred a buyback program with a purchasing approval of $500 million), and people buying at any given price might have different total return experiences if they liquidated today, the company has a long-running history of paying quarterly dividends, and consistently raising them.
There's been a lot of cheap talk about ACAS' NAV being basically bogus or at least unknowable by investors, with the illiquid nature of ACAS' holdings cited as proof ACAS could lie and never be caught. The facts speak otherwise. ACAS routinely exits holdings, and gets for them what ACAS says they're worth. If HP didn't think Extream Software wasn't worth $5m more than ACAS had claimed on its prior quarterly report, would HP have paid it? Moreover, last year ACAS became the manager of a private equity fund, American Capital Equity II, that began life by buying a 17% cross-section of ACAS' portfolio companies, paying within 3% of the price ACAS had last said was the fair price for them. If the sale prices in arms-length transactions are really within a few percent of what ACAS says, where's the evidence the valuations are gamed?
Management at ACAS offer this on the subject:
First: What Is ACAS' Business?
ACAS is regulated as a business development company. Unlike most companies whose dividends to shareholders result in double-taxation, ACAS avoids federal income taxes on dividends paid to shareholders provided it pays at least 90% of its earnings to shareholders every year. To keep ACAS' tax status as a BDC and as a regulated investment company, ACAS is required to make the payments it does, because its earnings are so high it can't pay much less and keep its tax status. When Cramer says of ACAS' dividend that it "sounds almost too good to be true" and that therefore "I don't like the stock" he is really saying that ACAS' earnings are scary high, and that the company's high, sustained, and growing profitability makes him hate the shares.
Think about that for a little bit.
ACAS has routinely paid a bit less than its total annual income in dividends, and has retained a small fraction of its earnings in order to roll into future years earnings not distributed to shareholders. This lets ACAS use part of the earnings for investment. Since ACAS doesn't want to be enslaved to some specific quarterly earnings number and doesn't want to have to game its income around some dividend predictions, having the rolled-forward earnings available as a cushion to cover dividends is helpful, but frankly I've never seen ACAS pay dividends that exceeded the year's realized gains so the likelihood is that rolled-forward earnings will simply tend to force ACAS to raise future dividends to keep ahead of its obligation to pay out 90% of its earnings in dividends. In other words, ACAS' performance creates a legal obligation to keep raising its dividends, as the price of its tax status.
Another feature of ACAS' tax status is that its leverage is limited. ACAS can't become too dangerously leveraged and retain its tax status, so ACAS retains a solid balance sheet and a solid credit rating. ACAS can borrow money vastly more cheaply than the going rate paid by companies who hope to borrow money from it, so ACAS can (and does) take advantage of credit dislocations to increase its spread on loans. That is, the difference between the rate at which it (a highly-rated borrower) can borrow money and the rate at which middle-market companies can get loans gets bigger during credit dislocations like the one that we're seeing now, so ACAS' opportunities to profit in debt transactions increases. The very credit issues that drive folks to bash ACAS actually increase its business opportunity.
ACAS' Profit Sources
As I stated, ACAS has three sources of profit:
First (not first in magnitude or in order of development, but in simplicity to communicate to readers), ACAS has contracts to manage other people's money. This means that the third-party funds ACAS manages -- these now total billions -- aren't a hobby, they're a profit center. In other words, instead of paying a fund manager to invest your money in stocks, ACAS' investors are in the happy position that other people are paying ACAS to do due diligence on deals and figure out how to deploy capital. This is because ACAS deploys its own capital right beside its managed capital; but ACAS charges clients for the due diligence and dealmaking in which ACAS itself participates. As ACAS' funds management business grows, so grows ACAS' income that is independent on the behavior of individual investments. With an annual fee of 2% of assets under management, and a 30% participation in profits, ACAS can make a good business out of doing good business.
The same due diligence ACAS conducts for its own investment, it can recycle for use in managed funds. Moreover, managed funds give ACAS free access to capital needed to pull off one-stop, quick buyouts that would force a less flexible company to seek co-investors and partners. Since ACAS gets management fees from the managed funds, and shares in profits, ACAS makes a good business investing managed money in the deals it wants to enter itself. Likewise, third parties are eager to be involved in ACAS' deals because they know ACAS is putting its own money into the deals. When ACAS sells off portfolio companies' senior debt, ACAS gets good prices in part because ACAS' buyers see ACAS happily retaining high-yield subordinate debt and even equity. Since the senior debt buyers know ACAS can't get paid unless and until the buyers get paid, they know ACAS isn't just trying to flee a bad deal -- they know ACAS stands behind the sale and believes in it. ACAS' position as it syndicates senior debt is superior to that of its competitors who deal only in debt and don't hold common shares, or aren't involved in as many facets of the buyout and aren't participating in junior levels of debt. But I'm getting ahead of myself, as this creeps up on ACAS' investment exits and its capital gains.
The second profit stream is devilishly simple: ACAS' portfolio companies make money. ACAS isn't merely a stock trader, trying to flip companies that may not pay dividends; ACAS owns stakes so large it must consolidate the portfolio companies' balance sheets, recording their profits as ACAS' own. Like Berkshire Hathaway has control over GEICO, ACAS has real control over the companies it owns -- though, like Berkshire, ACAS isn't trying to replace good managers with some MBA beanhead who doesn't know the business. And unlike the Cramers of the world, ACAS need never exit a company that has little interest among buyers but is making money. ACAS, like Berkshire, can sit back and just take the revenues. The newly-mandatory accounting standard, FAS 157, that was hailed as the hammer that would shatter ACAS, actually has some interesting effects in this regard:
And the kicker? Today, ACAS' shares closed below the last-published net asset value. Thus today, ACAS is on sale twice.
And that brings us to the third source of profit ACAS enjoys. ACAS got its start, way before it went public in the late 1990s, helping employees buy their employers. Malon Wilkus, ACAS' CEO, had spent a stint in a commune making goods to support the commune's operations before giving up in disgust after realizing the commune's "everybody shares" rule had created and sustained a class of loafers who didn't pull their weight, leaving the 20% of the folks doing the work to earn a measly $1500 a year. (The fact that Wilkus' hammock business pulled in a million bucks a year after he bagged Pier 1 as a customer didn't qualify him for a raise: link) Wilkus apparently wanted to help those who wanted to help themselves, and started arranging for working people to become owners of their employers' businesses, so they would reap the profits of their labors.
Power To The People!
Wilkus' post-1983 work proves the tools of capitalism can be employed to empower the workers who make earnings possible. After a stint "at the Calvert Funds, which ran many socially responsible mutual funds" Wilkus quit to form American Capital expressly to help workers take over their employers through stock ownership programs. (link) Workers typically ended up with 80% ownership, and Wilkus was often paid in shares, sharing the remaining ownership with managers. After arranging in the mid-'90s to save breadmaker Four S through a series of transactions that culminated in its sale to the Mexican bread giant Groupo Bimbo (a deal that doubled the money of employees, who took a pay cut to keep the company afloat while the deal was underway), Wilkus seemed to accelerate conducting complex multi-tiered buyout transactions.
In the big bad world, lots of folks have businesses from which they would like to extract value. Entrepreneurs who aren't ready to give up management may nevertheless want to trade the bulk of their shares for an opportunity to pull some cash out out of their essentially illiquid business ownership. Thus, the world is awash in businesses that are doing just fine, but whose owners are worried that there's no easy way to divide the business when they die, or who have some other equally benign reason to want to turn some ownership into cash. Some of the sellers want absurd prices for their businesses, and some are willing to make a deal that leaves a lot of room for everyone to make money. Since valuing these illiquid businesses is something of a trick, and there can be lots of pieces to the transaction (money borrowed to make the transaction affordable, divided into junior and senior debt to be borne by the company; shares sold in both common and preferred classes; intermediate financing while all this is being arranged; loans taken on to fund planned expansions; etc.), it can be a miserable and lengthy task to get all the necessary parties lined up with enough capital to make it happen.
Enter ACAS. ACAS manages over twenty billion smackers for investment in middle-market companies, and has shown historic ability to raise capital by issuing shares above its net asset value (that is, issuing shares that enrich existing shareholders rather than merely dilute them out). It's done this consistently, for years. And because of its present size, ACAS can do what no-one else will: it can offer a single stop for making all facets of the transaction happen in a middle-market buyout. A multibillion-dollar buyout might attract interest from one of the major investment banking firms, but these smaller fish ... there's just no-one else interested in their deals and can make the whole thing happen alone. So ACAS, which has trademarked the phrase One Stop Buyout™, is the buyer of choice. Thus, ACAS sees more deals than its competitors -- and it can cherry-pick the best deals available in the market. When a price becomes too steep, ACAS just walks away: like the song says, there are just too many fish in the sea. ACAS has a great advantage in its third line of business, in that it gets to cherry-pick the best deals to be had in the middle market.
What's better for shareholders, ACAS is happy to walk away from deals that aren't good enough. As demonstrated in a 2007 conference call, ACAS will readily sacrifice a quarterly number if needed to protect the long-term good of the firm. ACAS is that rarest of companies: one whose management's interest appears -- based on its conduct, not mere press releases -- genuinely aligned with the interests of the long-term shareholders. The number of rejected deals is just outstanding -- but there is such an avalanche, ACAS has no trouble finding a few gems worth buying.
Since ACAS need only swing at the best pitches, ACAS' batting average is excellent. You can check it out here, strikes and home runs alike. You can also have a look at investments not yet exited. Sure, there's some negative return ... but the vast bulk of the deals are good, and the mean is a solid double-digit return. And while they are in process, there are always those quarterly earnings ....
And what was it Cramer said? American Capital is allegedly "a financial that owns very difficult companies to be able to make a lot of money in right now. It's very, very high risk." Cramer is right that it's hard to make money in these companies the way Cramer makes money, by trading in and out, because illiquidity complicates and adds risk to valuation estimates. If you planned to sell illiquid companies in uncertain times, but had to enter deals under good-case price multiples, you'd need outrageous results just to keep up. High risk, indeed. Thankfully, that's not ACAS' business.
Look at the obverse of Cramer's observation: if nobody can get top dollar for their companies due to illiquidity and its impact on valuation multiples, think what a screaming buy ACAS will be getting on every entry it makes. After all, nobody has a gun to ACAS' head forcing ACAS to liquidate anything, or to go for bad deals. ACAS can patiently pocket the profits from its portfolio companies until it sees good exit opportunities. ACAS doesn't need to make money Cramer's way. Indeed, most of ACAS' profits are operating profits from portfolio companies and management income. Since ACAS routinely models for exits under worse price-to-earnings multiples than those obtaining at the time it enters deals, the possibility that multiples have been compressed doesn't spell doom for ACAS' exit opportunities.
The Upshot
This entry surely comes off as a long, complex sales pitch for ACAS. This is because I'm laughing at the simplicity of the criticisms folks have laid on ACAS when they were paid to do entertain the public. Every criticism I've seen published about ACAS has been rooted in a wild misunderstanding of ACAS' business model, and some have been exactly wrong about the impact on ACAS of the trend they decided would be exciting for people to worry about the day they published. So I offer this thought: analysts aren't risking money when they tell you what is and is not a solid investment. Analysts need not even make sense if they hit enough good high-click terms in their blathering. (Here: iPod, recession, peak oil, interest rates, multiple compressions, accounting scandal. Now, with an Analyst-themed Mad-Libs, you too can sound like you have deep understanding of an impending investment collapse!)
Warren Buffett said a few things that are worth keeping in mind as you consider the wild news that surrounds publicly-traded companies. When American Express was being sold hand over fist in the wake of a scandal involving companies that lied about collateral pledged to back a few million in loans (salad oil floats on water, so tankers that looked like they were full of salad oil were, you know, mostly full of sea water -- oops), Mr. Buffett looked at the company's basic business and looked at the amount of money involved in the suspect transactions, and realized the public reaction was so utterly out of proportion to the news (the purported reason for the stock price collapse) that he invested in the company (and he hasn't sold yet ... this scandal was in the '60s, and he's still taking dividends). In keeping with his now-famous piece of investment philosophy, Buffett acquired a sizeable stake in American Express. (The quote to which I refer, and which Buffett is so often cited for, is: Be Fearful When Others Are Greedy And Greedy When Others Are Fearful.)
Just disagreeing with the public at large isn't enough to do well in investing, however. A thoughtless contrarian could have gone broke in Enron buying on the way down, just to buck the trend. The key is realizing that the public is missing something important and deciding, on the basis of solid business valuation principles, that the investment at issue is not currently priced correctly. There is a whole horde of Econ 101 children with propellers on their heads who will argue that the market is efficient, etc., and therefore everything is priced so as to reflect all the publicly-available knowledge, etc. This tripe has the strength of being easy to find repeated by folks who've had the same freshman Econ class, but the fact remains that the assertion is not true. Were it true, people like Buffett who look for boring, easily comprehensible businesses (like making bread, maybe) and invest in them when it's clear everybody's priced the business wrong, would never actually make a profit because nothing would ever be priced wrong in a way any human with access only to ordinary, publicly-available information could tell. And that's bogus. In 2003, Forbes had this to say after interviewing Warren Buffett:
Yet, according to the talking heads, ACAS is a scary stock and it's time to run. But that's OK. Run for your life. Short it, even. I've enrolled in the dividend reinvestment plan, and the lower the price is on the dividend date, the more of those shares I get, and every quarter the dividend is getting bigger and bigger so I sure do want more of those shares.
Down, down, down on dividend date, that's my prayer. In the meantime ... just because it's quality entertainment doesn't mean it's quality news.
Jim Cramer is utterly unafraid to take a strong position. Whether it's to buy Sears (SHLD) at 180 or -- as just recently -- to sell American Capital Strategies (ACAS) at under 28, there's little reason ever to think Mr. Cramer is soft-pedaling his opinion. Not that Cramer is married to his analysis; after preaching the virtues of Sears as a working-man's hedge fund and the turnaround genius of Eddie Lampert in a video touting Sears as one of a series of stocks likely to become Berkshire Hathaway-style single-share retirement funds, Cramer posted about SHLD that folks could short it. And there, I suppose, is the take-home lesson: the folks who get interviewed to opine on stocks aren't in front of the camera because they're right, but because they're entertaining.
That we have a media environment that is based on entertainment rather than truth is something with some interesting and far-reaching consequences as consumers, including as investors. More on that in a later post -- it's a big deal. The main application here is that the story that's easiest to find is probably easy to find because it's exciting, not because it's the most accurate. Excitement means clicks, links, eyeballs, and ad revenue. Truth -- well, who knows whether it's true? But we can tell pretty quickly if it's entertaining. You don't have to be Warren Buffett or Socrates to notice who keeps you on the edge of your seat when they talk.
So let's -- you know, just for fun -- have a look at Cramer's recent thumbs-down on American Capital:
In the end it's a financial that owns very difficult companies to be able to make a lot of money in right now. It's very, very high risk. The dividend sounds almost too good to be true. I don't like the stock
via Seeking Alpha
Let's look at the business for a moment. American Capital Strategies Ltd. has developed three profit streams. And let me be clear: these aren't just revenue streams, or business plans, they're honest-to-goodness, proven profit streams. Allow me to spell this out for those who haven't heard it. Since going public in 1997 at a price of $15 per share, ACAS has paid over $25 in dividends, and last quarter had a GAAP net asset value of over $28 per share[1]. I understand that in the wake of Enron and WorldCom there's a certain amount of skepticism regarding accounting practices and valuations, and I'll ignore for the moment the serious problems applying these concerns to this particular company's assets -- but you can't restate dividends you've actually paid. Those are paid already. While the shares have vacillated between trading above net asset value and trading below net asset value (which spurred a buyback program with a purchasing approval of $500 million), and people buying at any given price might have different total return experiences if they liquidated today, the company has a long-running history of paying quarterly dividends, and consistently raising them.
There's been a lot of cheap talk about ACAS' NAV being basically bogus or at least unknowable by investors, with the illiquid nature of ACAS' holdings cited as proof ACAS could lie and never be caught. The facts speak otherwise. ACAS routinely exits holdings, and gets for them what ACAS says they're worth. If HP didn't think Extream Software wasn't worth $5m more than ACAS had claimed on its prior quarterly report, would HP have paid it? Moreover, last year ACAS became the manager of a private equity fund, American Capital Equity II, that began life by buying a 17% cross-section of ACAS' portfolio companies, paying within 3% of the price ACAS had last said was the fair price for them. If the sale prices in arms-length transactions are really within a few percent of what ACAS says, where's the evidence the valuations are gamed?
Management at ACAS offer this on the subject:
Under our previous valuation policies [before the accounting standard FAS 157 became mandatory and forced hundreds of millions in paper write-downs in portfolio company valuations], the proceeds American Capital realized on $10 billion of investments exceeded the prior quarter valuations on average by less than 1%. In the future, we intend to report the anticipated realizable values on settlement or maturity of our investments as well as GAAP values so investors can consider both.In other words, before the new accounting rules, ACAS with the aid of outside valuation experts was able to state with something like 99% accuracy the real-world value -- as proven by genuine sales to honest-to-goodness bona fide buyers in arms-length transactions -- of its holdings. To the extent ACAS has been required by regulators to state in its regular filings some lesser valuation, one would suspect the valuations would be understated. Stock movements based on the spurious valuations would be bargain opportunities.
via ACAS' Form 10-Q filed May 6, 2008.
First: What Is ACAS' Business?
ACAS is regulated as a business development company. Unlike most companies whose dividends to shareholders result in double-taxation, ACAS avoids federal income taxes on dividends paid to shareholders provided it pays at least 90% of its earnings to shareholders every year. To keep ACAS' tax status as a BDC and as a regulated investment company, ACAS is required to make the payments it does, because its earnings are so high it can't pay much less and keep its tax status. When Cramer says of ACAS' dividend that it "sounds almost too good to be true" and that therefore "I don't like the stock" he is really saying that ACAS' earnings are scary high, and that the company's high, sustained, and growing profitability makes him hate the shares.
Think about that for a little bit.
ACAS has routinely paid a bit less than its total annual income in dividends, and has retained a small fraction of its earnings in order to roll into future years earnings not distributed to shareholders. This lets ACAS use part of the earnings for investment. Since ACAS doesn't want to be enslaved to some specific quarterly earnings number and doesn't want to have to game its income around some dividend predictions, having the rolled-forward earnings available as a cushion to cover dividends is helpful, but frankly I've never seen ACAS pay dividends that exceeded the year's realized gains so the likelihood is that rolled-forward earnings will simply tend to force ACAS to raise future dividends to keep ahead of its obligation to pay out 90% of its earnings in dividends. In other words, ACAS' performance creates a legal obligation to keep raising its dividends, as the price of its tax status.
Another feature of ACAS' tax status is that its leverage is limited. ACAS can't become too dangerously leveraged and retain its tax status, so ACAS retains a solid balance sheet and a solid credit rating. ACAS can borrow money vastly more cheaply than the going rate paid by companies who hope to borrow money from it, so ACAS can (and does) take advantage of credit dislocations to increase its spread on loans. That is, the difference between the rate at which it (a highly-rated borrower) can borrow money and the rate at which middle-market companies can get loans gets bigger during credit dislocations like the one that we're seeing now, so ACAS' opportunities to profit in debt transactions increases. The very credit issues that drive folks to bash ACAS actually increase its business opportunity.
ACAS' Profit Sources
As I stated, ACAS has three sources of profit:
First (not first in magnitude or in order of development, but in simplicity to communicate to readers), ACAS has contracts to manage other people's money. This means that the third-party funds ACAS manages -- these now total billions -- aren't a hobby, they're a profit center. In other words, instead of paying a fund manager to invest your money in stocks, ACAS' investors are in the happy position that other people are paying ACAS to do due diligence on deals and figure out how to deploy capital. This is because ACAS deploys its own capital right beside its managed capital; but ACAS charges clients for the due diligence and dealmaking in which ACAS itself participates. As ACAS' funds management business grows, so grows ACAS' income that is independent on the behavior of individual investments. With an annual fee of 2% of assets under management, and a 30% participation in profits, ACAS can make a good business out of doing good business.
The same due diligence ACAS conducts for its own investment, it can recycle for use in managed funds. Moreover, managed funds give ACAS free access to capital needed to pull off one-stop, quick buyouts that would force a less flexible company to seek co-investors and partners. Since ACAS gets management fees from the managed funds, and shares in profits, ACAS makes a good business investing managed money in the deals it wants to enter itself. Likewise, third parties are eager to be involved in ACAS' deals because they know ACAS is putting its own money into the deals. When ACAS sells off portfolio companies' senior debt, ACAS gets good prices in part because ACAS' buyers see ACAS happily retaining high-yield subordinate debt and even equity. Since the senior debt buyers know ACAS can't get paid unless and until the buyers get paid, they know ACAS isn't just trying to flee a bad deal -- they know ACAS stands behind the sale and believes in it. ACAS' position as it syndicates senior debt is superior to that of its competitors who deal only in debt and don't hold common shares, or aren't involved in as many facets of the buyout and aren't participating in junior levels of debt. But I'm getting ahead of myself, as this creeps up on ACAS' investment exits and its capital gains.
The second profit stream is devilishly simple: ACAS' portfolio companies make money. ACAS isn't merely a stock trader, trying to flip companies that may not pay dividends; ACAS owns stakes so large it must consolidate the portfolio companies' balance sheets, recording their profits as ACAS' own. Like Berkshire Hathaway has control over GEICO, ACAS has real control over the companies it owns -- though, like Berkshire, ACAS isn't trying to replace good managers with some MBA beanhead who doesn't know the business. And unlike the Cramers of the world, ACAS need never exit a company that has little interest among buyers but is making money. ACAS, like Berkshire, can sit back and just take the revenues. The newly-mandatory accounting standard, FAS 157, that was hailed as the hammer that would shatter ACAS, actually has some interesting effects in this regard:
[A]t the end of the first quarter of 2008, the Company held an investment in a commercial real estate collateralized debt obligation (CRE CDO) which had been depreciated $209 million from its inception to date, including $160 million in the first quarter of 2008. The investment is currently producing approximately $8 million per quarter of cash flow but its current fair value determined in accordance with GAAP is $11 million due to a lack of liquidity in the financial markets for CDO investments which has caused investment spreads to widen. However, the Company anticipates realizing its $220 million investment on settlement or maturity based on its assumptions of future credit losses, which includes a recession over the life of the investment.So, an investment that is genuinely expected to yield $8m/quarter is required by newly-mandatory rules (FAS 157) to be listed as though it were worth $11m, even though there's no pressure to dump the asset into a market that might pay $11m for it. If I could own an asset that returned 73% per quarter, I'd be a very happy consumer. Unfortunately for me as a buyer, this is an extreme case and ACAS' value isn't this misstated in every investment. On the other hand, if ACAS' valuations have historically been within 1% of correct, and suddenly were required by regulations and not due to business changes to be marked down more than 10% of their stated value, one would expect ACAS' NAV to be misstated by regulatory requirement by about 10% to the downside.
via ACAS' Form 10-Q filed May 6, 2008.
And the kicker? Today, ACAS' shares closed below the last-published net asset value. Thus today, ACAS is on sale twice.
And that brings us to the third source of profit ACAS enjoys. ACAS got its start, way before it went public in the late 1990s, helping employees buy their employers. Malon Wilkus, ACAS' CEO, had spent a stint in a commune making goods to support the commune's operations before giving up in disgust after realizing the commune's "everybody shares" rule had created and sustained a class of loafers who didn't pull their weight, leaving the 20% of the folks doing the work to earn a measly $1500 a year. (The fact that Wilkus' hammock business pulled in a million bucks a year after he bagged Pier 1 as a customer didn't qualify him for a raise: link) Wilkus apparently wanted to help those who wanted to help themselves, and started arranging for working people to become owners of their employers' businesses, so they would reap the profits of their labors.
Power To The People!
Wilkus' post-1983 work proves the tools of capitalism can be employed to empower the workers who make earnings possible. After a stint "at the Calvert Funds, which ran many socially responsible mutual funds" Wilkus quit to form American Capital expressly to help workers take over their employers through stock ownership programs. (link) Workers typically ended up with 80% ownership, and Wilkus was often paid in shares, sharing the remaining ownership with managers. After arranging in the mid-'90s to save breadmaker Four S through a series of transactions that culminated in its sale to the Mexican bread giant Groupo Bimbo (a deal that doubled the money of employees, who took a pay cut to keep the company afloat while the deal was underway), Wilkus seemed to accelerate conducting complex multi-tiered buyout transactions.
In the big bad world, lots of folks have businesses from which they would like to extract value. Entrepreneurs who aren't ready to give up management may nevertheless want to trade the bulk of their shares for an opportunity to pull some cash out out of their essentially illiquid business ownership. Thus, the world is awash in businesses that are doing just fine, but whose owners are worried that there's no easy way to divide the business when they die, or who have some other equally benign reason to want to turn some ownership into cash. Some of the sellers want absurd prices for their businesses, and some are willing to make a deal that leaves a lot of room for everyone to make money. Since valuing these illiquid businesses is something of a trick, and there can be lots of pieces to the transaction (money borrowed to make the transaction affordable, divided into junior and senior debt to be borne by the company; shares sold in both common and preferred classes; intermediate financing while all this is being arranged; loans taken on to fund planned expansions; etc.), it can be a miserable and lengthy task to get all the necessary parties lined up with enough capital to make it happen.
Enter ACAS. ACAS manages over twenty billion smackers for investment in middle-market companies, and has shown historic ability to raise capital by issuing shares above its net asset value (that is, issuing shares that enrich existing shareholders rather than merely dilute them out). It's done this consistently, for years. And because of its present size, ACAS can do what no-one else will: it can offer a single stop for making all facets of the transaction happen in a middle-market buyout. A multibillion-dollar buyout might attract interest from one of the major investment banking firms, but these smaller fish ... there's just no-one else interested in their deals and can make the whole thing happen alone. So ACAS, which has trademarked the phrase One Stop Buyout™, is the buyer of choice. Thus, ACAS sees more deals than its competitors -- and it can cherry-pick the best deals available in the market. When a price becomes too steep, ACAS just walks away: like the song says, there are just too many fish in the sea. ACAS has a great advantage in its third line of business, in that it gets to cherry-pick the best deals to be had in the middle market.
What's better for shareholders, ACAS is happy to walk away from deals that aren't good enough. As demonstrated in a 2007 conference call, ACAS will readily sacrifice a quarterly number if needed to protect the long-term good of the firm. ACAS is that rarest of companies: one whose management's interest appears -- based on its conduct, not mere press releases -- genuinely aligned with the interests of the long-term shareholders. The number of rejected deals is just outstanding -- but there is such an avalanche, ACAS has no trouble finding a few gems worth buying.
Since ACAS need only swing at the best pitches, ACAS' batting average is excellent. You can check it out here, strikes and home runs alike. You can also have a look at investments not yet exited. Sure, there's some negative return ... but the vast bulk of the deals are good, and the mean is a solid double-digit return. And while they are in process, there are always those quarterly earnings ....
And what was it Cramer said? American Capital is allegedly "a financial that owns very difficult companies to be able to make a lot of money in right now. It's very, very high risk." Cramer is right that it's hard to make money in these companies the way Cramer makes money, by trading in and out, because illiquidity complicates and adds risk to valuation estimates. If you planned to sell illiquid companies in uncertain times, but had to enter deals under good-case price multiples, you'd need outrageous results just to keep up. High risk, indeed. Thankfully, that's not ACAS' business.
Look at the obverse of Cramer's observation: if nobody can get top dollar for their companies due to illiquidity and its impact on valuation multiples, think what a screaming buy ACAS will be getting on every entry it makes. After all, nobody has a gun to ACAS' head forcing ACAS to liquidate anything, or to go for bad deals. ACAS can patiently pocket the profits from its portfolio companies until it sees good exit opportunities. ACAS doesn't need to make money Cramer's way. Indeed, most of ACAS' profits are operating profits from portfolio companies and management income. Since ACAS routinely models for exits under worse price-to-earnings multiples than those obtaining at the time it enters deals, the possibility that multiples have been compressed doesn't spell doom for ACAS' exit opportunities.
The Upshot
This entry surely comes off as a long, complex sales pitch for ACAS. This is because I'm laughing at the simplicity of the criticisms folks have laid on ACAS when they were paid to do entertain the public. Every criticism I've seen published about ACAS has been rooted in a wild misunderstanding of ACAS' business model, and some have been exactly wrong about the impact on ACAS of the trend they decided would be exciting for people to worry about the day they published. So I offer this thought: analysts aren't risking money when they tell you what is and is not a solid investment. Analysts need not even make sense if they hit enough good high-click terms in their blathering. (Here: iPod, recession, peak oil, interest rates, multiple compressions, accounting scandal. Now, with an Analyst-themed Mad-Libs, you too can sound like you have deep understanding of an impending investment collapse!)
Warren Buffett said a few things that are worth keeping in mind as you consider the wild news that surrounds publicly-traded companies. When American Express was being sold hand over fist in the wake of a scandal involving companies that lied about collateral pledged to back a few million in loans (salad oil floats on water, so tankers that looked like they were full of salad oil were, you know, mostly full of sea water -- oops), Mr. Buffett looked at the company's basic business and looked at the amount of money involved in the suspect transactions, and realized the public reaction was so utterly out of proportion to the news (the purported reason for the stock price collapse) that he invested in the company (and he hasn't sold yet ... this scandal was in the '60s, and he's still taking dividends). In keeping with his now-famous piece of investment philosophy, Buffett acquired a sizeable stake in American Express. (The quote to which I refer, and which Buffett is so often cited for, is: Be Fearful When Others Are Greedy And Greedy When Others Are Fearful.)
Just disagreeing with the public at large isn't enough to do well in investing, however. A thoughtless contrarian could have gone broke in Enron buying on the way down, just to buck the trend. The key is realizing that the public is missing something important and deciding, on the basis of solid business valuation principles, that the investment at issue is not currently priced correctly. There is a whole horde of Econ 101 children with propellers on their heads who will argue that the market is efficient, etc., and therefore everything is priced so as to reflect all the publicly-available knowledge, etc. This tripe has the strength of being easy to find repeated by folks who've had the same freshman Econ class, but the fact remains that the assertion is not true. Were it true, people like Buffett who look for boring, easily comprehensible businesses (like making bread, maybe) and invest in them when it's clear everybody's priced the business wrong, would never actually make a profit because nothing would ever be priced wrong in a way any human with access only to ordinary, publicly-available information could tell. And that's bogus. In 2003, Forbes had this to say after interviewing Warren Buffett:
The most famous investor in the U.S. prefers not to invest in common stocks, because he doesn't see an opportunity to make a 10% after-tax return. "When stocks get mispriced periodically we will buy them if they are in the right relation to intrinsic value," he said. "Occasionally, over a 30-year period, stocks sell at a favorable relationship to intrinsic value."When an occasional mispricing occurs in publicly-traded shares, of course, life changes. And in shares that are not publicly traded, the opportunity for mispricing is even greater for investors skilled (as are ACAS' personnel) in discerning the likely value of an enterprise. In ACAS, we have both opportunities: a company whose assets are illiquid and hard to price are almost certainly mispriced when valued according to the accounting standards now in force, and the company's own shares have been driven below this discounted rate, in an environment in which pricing on debt and on private companies is likely to be so constrained that ACAS will have the best buying opportunities it's had in years.
Lenzner, "Life After Buffett", Forbes 5/5/2003
Yet, according to the talking heads, ACAS is a scary stock and it's time to run. But that's OK. Run for your life. Short it, even. I've enrolled in the dividend reinvestment plan, and the lower the price is on the dividend date, the more of those shares I get, and every quarter the dividend is getting bigger and bigger so I sure do want more of those shares.
Down, down, down on dividend date, that's my prayer. In the meantime ... just because it's quality entertainment doesn't mean it's quality news.
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