Value Investing using Economic Value Added (EVA)

Americans Need those Ipods, Cell Phones, Big Flat Screen TVs & the Internet

Great article on Carpe Diem about what we consider "necessities" in these tough time.

Of 12 items tested, six dropped significantly in the necessity rankings from 2006 to 2009, while the other six basically held their own. All of the "old-tech" household appliances on the list dropped in their necessity ratings. For example, the proportion of people who rate a clothes dryer as a necessity fell by 17 percentage points in the past three years. There are similar declines for the home air conditioner (16 points), the dishwasher (14 points) and the television set (12 points).

In contrast, none of the newer information-era gadgets and services has fallen in Americans' assessment of what they absolutely need to have. Cell phones and home computers continue to be seen as a necessity by half of the public, unchanged from three years ago. High-speed Internet access is seen as a necessity by about three-in-ten adults, also unchanged from 2006. Two items that came onto the consumer scene in this decade -- iPods and flat-screen TVs -- are still seen as a necessity by a very small share of the public, but that share hasn't declined during the recession.

The Cell Phone (ipod), Internet and Big Flat Screen TV.  That's why Best Buy (BBY) keeps exceeding expectations.

 

 

BERK

The Radical Experiment in Pay Regulation under TARP

Mark Hodak, my friend and colleague, who worked on the original Shareowner Alignment Index that sparked our idea of measuring and investing in companies whose management team was most closely alignedwith shareowners.

This is an excerpt from the second in a two-part series on executive compensation and financial service regulation. Marc's part one article examines the short history of executive compensation and how it is influencing today’s policy debate over regulation reform.

Most people in and out of the financial industry believe that perverse incentives were at least partly responsible for the crisis prompting the TARP program, initiated in the Emergency Economic Stabilization Act (EESA). Stronger alignment of managers and shareholders would likely have prevented much of the damage we are now facing, and it’s sensible that financial services reforms address those incentives. (my emphasis; this stronger alignment also eliminates shenanigans and poor performance at non-financial companies as well) EESA includes a provision that calls on the elimination of compensation that creates “unnecessary and excessive risks,” a provision reiterated in the American Recovery and Reinvestment Act (ARRA).

Unfortunately, EESA and AARA depend on the Treasury Secretary to make distinctions about what incentives do or do not contribute to excessive and unnecessary risk. This is not an easy call. Even the most seasoned corporate boards, with considerable experience in managing or overseeing financial services firms, have a very difficult time distinguishing compensation-induced risk, even without the political considerations that might drive directors to conflate governance risk and business risk.

For instance, most people equate compensation plans with steep pay-for-performance lines as “riskier” than plans with weaker incentives. Critics argue that stronger incentives induce reckless behavior. In fact, shareholders have been placed in far more danger when the incentive leverage is zero than when it’s steep. The area below targets or goals where there is no longer any more pay-for-performance is where the trader finds his or her greatest temptation to double down in the hope of getting back into the green. This phenomenon is well known in banking circles as the “trader’s option.” The fundamental problem is not the steepness of the plan when the participants are on the incentive line, but the discontinuous incentive leverage across the spectrum of performance. This problem is reinforced by discontinuities across time, characteristic of bonus plans with specific end dates, like the November 30 fiscal year-end for many banks, which means to a manager that anything that happens after that date is of no consequence to my bonus this year. These discontinuities create asymmetry between the risk preferences of the employee versus the shareholders.

Marc Hodak is Managing Director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance. Marc teaches corporate governance at New York University’s Leonard N. Stern School of Business. He can be reached at mhodak@hodakvalue.com.

President Obama Owns The Stupid Stress Tests

The latest news on the the top banks' stress tests is going to be a major focus for the markets over the next three weeks. The latest date on which we are purported to receive the results are due to be published May 4, although some of the results could well be revealed (leaked) prior to that date.

 

Today, we hear that the federal government will be putting restrictions on the banks that want to give back TARP money as soon as possible.

 

So let me get this straight. Barney Frank & Co. tells the big bad bank executives that if they want to give back the money they should give it right back. But now that Barney Frank & Co. realize that they have no leverage on running those banks when they give the money back, his lackeys in the Treasury Department get religion and leak that they are no longer going to take back that money without any conditions. In fact, there are reports today that those conditions will include the Treasury department's certification that giving back the money will not do systematic harm to the nation's banking system. Who decides - the Treasury Department.

 

If anybody is wondering why the market is down so much this morning-there you go. The government just couldn't stay out of the way long enough for the market to gain enough traction for people to start feeling good again.

 

Tom Brown at BankStocks.com reports today that President Obama himself created these idiotic stress tests that would magically heal the banking system. If it was anyone else in the administration I am sure that the adults would have pointed out to the president that he has any number of regulators whose job it is to consistently stress test the banks let alone the banks' own managers that stress test their capital all the time.

 

But when you're there most powerful man in the world and have no knowledge of business or finance why not make your own plan? Tom Brown writes today in Bankstocks.com:

 

The Stress Test Is Useless. Or Worse.
Lots of possible outcomes. None of them good.

President Obama himself is said to have hatched the idea, which is unfortunate. If it had been anyone else, then presumably Larry Summers or Tim Geithner would have pointed out that, um, regulators already stress test banks all the time in the course of overseeing the industry. And those on-site regulators already know a lot more about those banks than any stress-testers in Washington would, and can tailor their tests accordingly. What’s more, it’s a terrible idea to make the test results public, since that might cause unnecessary anxiety among depositors and even, in an extreme case, cause a run for no reason.

But the president must have hit Larry and Tim with one of those visionary-looks-off-into-the-future of his, so stress-test it was. The banks submitted their data weeks ago, and were instructed by the regulators to keep mum on the process. The entire financial industry has been on tenterhooks ever since.

Let’s take a look at what’s so wrong about this misbegotten idea:

1.      The underlying premise of the test is simply mistaken. From what I gather, certain economists reportedly convinced President Obama that the problem with the economy is that banks are refusing to lend, and are instead hoarding capital in order to shore up their wobbly balance sheets. The president seems to think, therefore, that if the banks are force-fed new capital, they can expand their balance sheets and resume lending, which would in turn help the economy begin to recover.

There’s just one problem with this thread of logic: its basic premise is wrong. The problem with the economy isn’t that banks that aren’t lending, it’s that the non-banks that make up the “shadow banking system” have gone into forced hibernation. We know the administration knows this, since it has expanded the TALF program, which is designed to help jumpstart the securitization markets on which the non-banks depend for their funding. (My emphasis)

As for the banks, well, the chart below tells the tale. It was developed by my old partner, Robert Albertson, now the chief strategist at Sandler O’Neill, and it shows bank loan growth during the current recession compared to the four previous recessions. If anything, bank lending has stayed remarkably robust in the face of shrinking demand.

 

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EVA Companies Have the Advantage in this Great Recession

Nearly every economist and serious investor accepts that shareowner value (not necessarily price, but value) is discounted cash flow (DCF) and DCF value (what we call "Fair Value" or "Intrinsic Value") implies that shareowners are better off when companies pay out any capital that is expected to earn less than the cost of that capital.

Despite wide acceptance of this principle - the closest thing that all economists agree on - very few companies use a capital efficiency measure like EVA in their top incentive plans.

In this short video free from the CFA Institute, Joel M. Stern explains the origins and applications of Economic Value Added (EVA), a metric that he invented at his firm, Stern Stewart & Co. In addition, Mr. Stern describes the current market conditions, the collapse of the “comparative advantage period,” and alternative sources of equity funding for public companies.

Pay careful attention to why Joel thinks companies should adopt strong incentives tied to EVA or another capital efficiency measure now to accelerate their recovery.

Joel Stern Video

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Wow! - That's Complex Evolutionary Deleveraging

The bears have consistently warned us of a protracted recession due to the arduous consumer deleveraging that would take a long time,  I don't think they counted on it happening this fast.

 

From Business Week, change in household debt outstanding.

The Great Recession might be over a lot sooner than many think.  Households have liquidated assets very fast to shed debt.  They feel much less wealthy, but their anxiety must be waning.  Good news none-the-less.

 

US births break baby boom record: 4,317,119

More babies were born in the United States in 2007 than any year in the nation's history, topping the peak during the baby boom 50 years earlier, federal researchers at the National Center for Health Statistics reported Wednesday.

in 2007, for the first time, the number of births in the United States eclipsed the previous record, set in 1957 at the peak of the postwar baby boom, and unchallenged ever since. (The 2007 number was 4,317,119.)

The new numbers suggest the second year of a baby boomlet.  On average, a U.S. woman has 2.1 babies in her lifetime. That's the "magic number" required for a population to replace itself. 

Countries with much lower rates - such as Japan and Italy - face future labor shortages and eroding tax bases as they fail to reproduce enough to take care of their aging elders. 

And this is another reason we need to fix the Great Recession soon.  The lowest birth rates occurred in the 1930s during the Great Depression and that was before there was modern contraception.  The U.S. is the only modern Western country whose birth rates have been increasing.  And it's a good thing too because it's likely that the current chaos will at least slow down the birth rate - and slow down the migration of the population with the highest birthrates - the hispanics.

It shows how disruptive and unique a demographic event the baby boom, those born between 1946 and 1964, was that it took 50 years for its peak year to be matched in terms of the absolute number of births.  Of course, the birth rate does not come close as percentage of a much smaller population back then.

And our current baby boomlet got me thinking about the eighty million of those boomers who are now age 45 - 63.  This entire baby boom generation just five months ago thought an early comfortable three-decade retirement was their entitlement. 

Then came September 2008. The financial system and the broader economy descended into chaos. Suddenly noone was talking about retirement but where to stash the cash earning virtually 0%.

These people were driving their brokers and advisors for more "performance" never asking about risk.  Well, now they don't not know when they are going to be able to retire—if they are going to be able to retire—and on what.  Now more than ever, they need to sit down with an advisor to start a retirement plan all over again.

Most important, they a need an advisor with a long-term mentality but who understands that traditional stock investing strategies need to be modified to make them effective in this kind of market - a range-bound market.

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AutoZone (AZO) Disciplined Value Based Management

What is Value Based Managment (VBM)?  There are many definitions.  But I think Warren Buffett explains it best:

“When managers are making decisions it’s vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious but we constantly see it violated

.” Warren Buffett, 1998 Berkshire Annual Report

 

One of our favorite companies is AutoZone (AZO) the autoparts retailer.

AutoZone is doing a great business in this Great Recesssion serving new demand from cost conscious customers looking to maintain their own car.  The stock price has responded as well.  It's up +18.5% year to date and +38.5% over the last 12 months.

Source: Bloomberg

At a Morgan Stanley Conference, management says that business remains good in Q2, as consumer behavior continues to change towards wanting to take care of their assets so that they last longer. 

In general, people are becoming more comfortable doing maintenance on their cars, as they look to save money. Also, the average age of a vehicle is now over 9 years. Cars over 7 years old are in the "sweet spot" for AZO since these cars are typically off warranties, and may be on their 2nd owner.

To the extent that they are seeing a benefit from dealerships closing, with business then shifting towards AZO, management says they haven't seen a huge change yet, but it is happening slowly. Management sees this as an opportunity going forward.

AZO believes it is in a good position in terms of inventory coverage, having invested over $300 mln in parts over the past few years. On the commercial side of the business, AZO now has 2,200 programs, and continues to focus on growing this side of the business. Mgmt feels that its enhanced parts coverage, its hub programs, and increased sales force position the company to increase penetration.

Why does this company "act in ways that increase per-share intrinsic value and avoid moves that decrease it."  Let's consider what drives up per share intrinsic value.

Intrinsic Value = Present Value (PV) of Future Cash Flows

PV of Future Cash Flows = Capital invested (which we can observe; debt + equity) +PV of Future Economic Value Added (EVA)

EVA = (Return on Invest Capital (ROIC) - Cost of Capital) * Capital

ROIC = Net Operating after Taxes (NOPAT)/Capital = NOPAT/Sales X Sales/Capital

That's the math!  Simple for accounting and number geeks like me but its also simple for non accounting types because it all boils down to managing short-term and long-term profit margins to increase the dollar amounts of EVA. 

1. Profit margin (NOPAT/Sales)

2. Capital (asset) Turnover (Sales/Capital)

3. Capital Growth (aka Capex and Investments) 

4. Use of excess cash if any - debt paydown, stock buyback and/or dividend.

To manage for value, then, we need to take actions that maximizes the amount of EVA dollars that we expect to make.  Notice we cannot simply maximize our profit margins by minimizing costs or raising prices.  We cannot minimize investments or capital expenditures only to maximize our return on invested capital because that might not maximize EVA dollars or Intrinsic value.

Instead the best business models and managment teams optimize each driver of intrinsic value to maximize intrinsic value.

But remember Mr. Buffett implores managers to act to increase per share intrinsic value. After all, unlike him, we own shares of these companies not the whole thing.  Ideally, for the long-term I would want a board that monitors increases in intrinsic value (or EVA) but also uses free cash flow that these high return businesses ordinarily generate to buy back stock and shrink the float, thereby increasing our ownership percentage of a growing pie.  That's the formula for excess returns over the long-term and is at the heart of our process. 

 

Let's look at the drivers for Autozone:

First, let's look at past and expected economic performance for the last 15 years.

Source: AfgView.com 

The first thing that strikes us is that the economic profit (same as EVA in dollars) has been positive for the last 15 years.  Next, we understand that the EVA has grown for most of the period except during 2007 - 2009 period.  Finally, after 2001 is when the EVA growth accelerated to unprecedented highs.  This was the period when value investor Eddie Lampert took a large stake in the company and instituted a Value Based Management program where only expenditures that had a high probability of earning 15% pre tax return on capital would be undertaken.  This discipline is exactly the discipline that Buffett has said he sees violated everyday.  Basically, growth is good but only when it will generate returns well above the cost of its capital - which leads to high and increasing EVA.

How did AZO do it - look at the profit margins and asset turnover below.

 Source: AfgView.com 

 The focus in 2001 was to increase margins mostly reducing costs and wasteful spending.  To increase EVA the cost structure was dramatically overhauled and took about 2.5 years.  Since then the EBITDA margin has been very consistent at industry highs around 19%.  This margin is now very stable even as the company has been extremely good at trading off between lower/higher gross margins and lower/higher fixed costs spread over a growing store base.

Source: AfgView.com 

The other way to increase ROIC is to increase turnover, sales per capital invested.  The efficiency is gained when capital growth is slower than sales growth.  But just because capital turnover is slightly decreasing above AZO has been able to increase EVA and ROIC because of the aforementioned careful and steady investment in inventory to inrease parts coverage, while at the same time that margins and or sales would increase to cover the higher capital costs.

The strategy as described by the numbers has been extremely successful, and has led to very high excess returns since the beginning of the VBM program.

Please also notice that we have not once talked about share price - management is not managing the stock market price of AZO. No, it's managing the intrinsic value per share which may or may not at any given time reflect that growing value.  Take a look at that growing realization of the increasing value below.

  Source: Bloomberg

AZO has obviously managed very well through the Great Recesssion and has shot up during the worst part of the panic.  But the most impressive part is that since 2001 when the company began its VBM program, the shareowner has made a lot of money.

But wait there is more! Look how the huge excess cash flow enabled the management to buy back oodles of stock so the number of shares outstanding has steadily fallen. 

Let's say we bought 10 million shares in 1998, when the shares outstanding were 152 million.  Our share of the ownership of the company will start at 6.9%.  If we simply kept the orginal 10 million shares, we would own 18% of the company in 2009!  And remember the dollar amount of EVA has been growing the whole time. 

That's why we invest in EVA companies or what we call Value-Aligned companies.  Management is not only capable but is aligned with our goal to increase intrinsic value per share by increasing EVA over time and reducing shares.

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Economic Plunge Taints All 50 States

A Philly Fed diffusion index monitors the number of states in the country that are contracting. In February, the index decreased in all 50 states for the first time ever.  Until recently, some of the natural resource states like Wyoming and Louisiana were able to fend off the recession.  Not anyomre.

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Soaking the Rich; Coming to Your Blue State Soon

Top marginal tax rates soared during the Great  Depression from 25% to 80%. I do not expect to see anything like that in this recession but we do see that many states are attempting to fill their budget shortfalls by sharply increasing taxes on their richest residents.

Take a look at page A4 of today’s Wall Street Journal, “States Try to Tap High Earners”.

Under a proposal by Gov. David Paterson, New York would follow California and Maryland in pushing its top earners into higher tax brackets that are several percentage points more than what most earners pay. And New Jersey is considering raising its top-tier income taxes even higher, to more than 10% compared with the 5.25% marginal rate paid by most households.

Several states are considering similar solutions as they face diminished revenue, yawning budget gaps and a populist political climate.

Seems fair some might say.  Let the highest earners pay more income taxes to soften the blow to those most vulnerable.  Trouble is that it always seems to do more harm than good. The WSJ continues:

Critics say the planned increase wouldn't hit just those in the financial industry. Small-business owners in New York are especially piqued, business groups say. Many report their business earnings on their personal income-tax returns and fear the additional tax load will constrict their enterprises. "You eliminate their ability to hire new employees, buy equipment, finance an expansion," said Mike Elmendorf, state director of the National Federation of Independent Businesses.

A 2008 analysis by the libertarian Cato Institute found that higher taxes suppressed economic growth and that locales that imposed an income tax to generate revenue had poorer growth rates than places that chose alternative taxes.

It's happening all over NJ.  People are leaving.  If they lose  their jobs they don't even bother looking for a new one in the NY metro area.  Why? It does not pay to try to be upwardly mobile.  A friend I have known for 30 years is moving to the South after her husband lost his job; two weeks later she's gone!

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