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Are Our Investments Still Profitable?
A couple of weeks ago I did a blog entitled “Time to Focus on What is Important” referring to the profit reporting season, where companies update shareholders on how they are going.
Well how are these businesses going?
Last year companies profitability suffered greatly because of an accounting term called “write downs”. This is when a company has an investment/asset on its books for certain value and then they reassess that value downwards as the asset is no longer worth that much money. One of the examples of this is with Crown Casino (CWN) who invested $1.377 billion in overseas casino operators, which include stakes in Cannery Casino Resorts LLC and Fontainebleau Resorts LLC. These investment are now on the books as they were “wrote down” in previous accounting periods to $50 million in the company’s accounts, or 3.6 percent of their original value. In this reporting season for the 6 months ending 31 December 2009 they are back to making money from the underlying casino operations, people gambling, with Melbourne casino making $243 million and Burswood Casino in Perth making $112 million. This is what we want to see as long term investors. Interestingly if the overseas assets recover they will then increase the value of those assets which will have the opposite impact to profitability from an accounting perspective.
Property companies are classic examples of this phenomenon of “write downs” as real estate values fall they reduce the assets value on the accounts (based on valuers valuations) even though the underlying asset will still be receiving rent (probably more than last year) and continuing to meet its expenses.
As investors we like to look at the “operating profit” of the business which excludes factors such as write downs and looks purely what the company does day in and day out be that gambling, collecting rent, selling groceries or whatever. As over the long term it’s the profitability of these operations that will constitute a company’s value proposition. The good news is that the operating profitability of these companies is expanding from where it was last year which is great news for us as owners of those businesses.
Good Investors Don’t “Look Busy”
With the plethora of news, rumours and whims that get thrown around in the media it is tempting for investors to “look busy” by constantly tinkering with their portfolio. This is counter productive and will not result in the best long term outcomes for investors.
Remember a share is ownership in a real business. In assessing the status of a business one needs to look at the performance of the underlying business, not the share price performance. Once you have determined the “quality” of the underlying business the share price simply tells you whether the business is cheap or expensive. To state the obvious, however it is often forgotten by investors, you buy a business when it is cheap and should it get to the point they are absurdly expensive then you look to sell. A scenario that frequently happens during booms such as the tech boom when Microsoft was valued at well over US$100 per share and today trades at about US$25. When the shares were at their height the underlying business was performing exceptionally well with annual profits growing over 30% per annum for a decade during the 90’s, a feat achieved by no other US company. However, the value people were willing to pay for this company was exorbitant and miles away from a “fair” price. In recent years we have seen a resources boom therefore should we be loading up on these trendy stocks?
Smarter men than myself have used this as the cornerstone for their investing “play book” so I will let them say it.
“Although it's easy to forget sometimes, a share is not a lottery ticket... it's part-ownership of a business”.
Peter Lynch
“When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30. You just don't know when you can find the bottom”.
Peter Lynch
“Most of the time common stocks (share market) are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed. For indeed, the investors chief problem, and even his worst enemy, is likely to be himself".
Benjamin Graham
“The financial markets generally are unpredictable. The idea that you can actually predict what's going to happen contradicts my way of looking at the market".
George Soros
“I buy when other people are selling.”
J Paul Getty
“The trouble, in my opinion, with corporate America today, is that everything is thought of in quarters” (reference to the short term thinking of investors).
Henry Kravis
“Most of our efforts are focused on understanding the dynamics of how a business works, what makes it unique, and the valuation that one should be willing to pay for it”.
Paul Moore
A Time For Focus on What Is Important
For share investors or business owners “Reporting Season” is the grand final of the football season or the Ashes series for cricket fans. It is where the companies report to shareholders about the underlying performance and ultimately profitability of their businesses. Investors trade shares pretty much all year round and a whole raft of factors influence markets from economic issues, natural disasters, acts of terrorism of implied threats of combat the list is pretty much endless. However, these few weeks provide a window to really focus on what we are trying to do in the long term....own a profitable business.
In the words of the famous money manager Peter Lynch, “I spend about fifteen minutes a year on economic analysis. I also spend fifteen minutes a year on where the stock market is going”.
As the US gets towards the end of their “Reporting Season” it is just starting in Australia. In the US at this stage more than 350 companies that are in the S&P 500 have reported earnings with about 75% of these beating expectations. How are the underlying businesses you own performing in terms of profitability, operationally and the future strategy they are implementing. This is the gauge of whether we want to be investing in a business not the share price, the share price just tells us whether a business is cheap or expensive.
Markets Going Down Again...What is the Big Picture?
So far this calendar year we have seen the return of “down” markets. Whether this has been as a result of sovereign debt issues in countries like Portugal and Greece, or because the Chinese wish to deliberately slow their economy, or the plethora of reason markets find to move either up or down on a daily basis.
As discussed we need to not worry too much about the market and really it is just a gauge to tell us whether a company is either cheap or expensive to buy. Naturally, after the market falls the business becomes cheaper so if after looking at the profitability and the fundamentals of the business and you like what you see it is obviously a buying opportunity. The classic scenario here in Australia was the banking sector which during the GFC the shares in which lost around 50% of their value however the profit for the one year only saw declines of about 5-10% for the banks. The decrease in valuation of these banks was not justified by the underlying fundamentals which saw share price increase dramatically to higher levels.
Placing the 10% fall from the highs in January in perspective is also important. The S&P500 (general share index for the broader market) in the US has risen 62% from the lows achieved in March 2009 to today’s closing price notwithstanding the 10% retracement. These retracements are natural and are not to be feared but to be embraced as buying opportunities.
Suckers That Own Businesses
An article written by Eric Dash from the New York Times recently broke down the level of bonuses that US firms paid their staff in the last year. Once you look at the figures it will demonstrate why President Obama is livid about the current situation given the US Government requirement to bail out most of these institutions in the last couple of years.
Across the board about 90 cents of each dollar of revenue earned by the banks is going towards employee salaries, bonuses and benefits. Analysis of the figures show that not only “performers” are taking home bonuses but also “underachievers”.
Citigroup paid a staggering $27 Billion in staff payments which wiped out every dollar of profit. The bank also had to pay back bail out dollars, so they could pay the bonuses, which left shareholders with an annual loss of $2 Billion. The reason given for such generous payments was to keep up with heavyweights of Wall Street such as Goldman Sachs. However, Goldman Sachs paid out only 45 cents of each dollar of revenue which is far more acceptable to shareholders and an equitable split of the profits. Interestingly, Warren Buffet now owns about $8 Billion of stock in Goldman Sachs so you know that these types of arrangements will need to be fair otherwise he will most definitely step in.
The notion of reward for performance seems to be getting lost and the owners of these business are the ones that cop losses but then in turn miss out on the spoils due to these obscene practices.
Wall Street big 5 banks last year collectively earned US$147 Billion before wages and tax. They then paid employees US$114 Billion, reinvested US $31 Billion back into their companies leaving a paltry US$2.1 Billion for their shareholders.
I grew up wanting to own a business, now I want to work in one of these institutions where you take no risk, get handsomely rewarded whether times are good or bad. Unfortunately, this is not a scenario specific to the US, it is a global phenomenon among all companies. Shareholders, especially institutional shareholders need to sort management out and have acceptable remuneration practices. After all if they don’t like it they can always take the risk and expense of running their own business which is a far cry from their current arrangement.
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