Vitaliy Katsenelson @vkatsenelson - Tumblr Blog

The Real Secret About Why Corporate Mergers Fail

Corporate acquisitions often fail for one simple reason: the buyer pays too much. An old Wall Street adage comes to mind: Price is what you pay, value is what you get. It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the last trade. When a company is acquired, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.

How much above? Acquisitions have the elements of a zero sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince both directors and shareholders that they are selling at a high (unfairly good) price. The buyer, meanwhile, must convince those same constituents that they are getting a bargain. Remember, both are talking about the same asset.

This is where a magic word — which must have been invented by Wall Street research labs — comes into play: synergy. The only way this acquisitions dance can work is if the buyer convinces his constituents that, by combining two companies, they’ll be able to create additional revenues otherwise not available to them, and/or they’ll be able to eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.

or you can also listen to the article here, listen through google podcast here, or apple podcast here.

#HP #GE

Mature Company Stocks Are Not Bonds

Like many professional investors, I love companies that pay dividends. Dividends bring tangible and intangible benefits: Over the last hundred years, half of total stock returns came from dividends.

In a world where earnings often represent the creative output of CFOs’ imaginations, dividends are paid out of cash flows, and thus are proof that a company’s earnings are real.

Finally, a company that pays out a significant dividend has to have much greater discipline in managing the business, because a significant dividend creates another cash cost, so management has less cash to burn in empire-building acquisitions.

Over the last decade, however, artificially low interest rates have turned dividends into a cult, where if you own companies that pay dividends then you are a “serious” investor, while if dividends are not a centerpiece of your investment strategy you are a heretic and need to apologetically explain why you don’t pray in the high temple of dividends.

I completely understand why this cult has formed: Investors that used to rely on bonds for a constant flow of income are now forced to resort to dividend-paying companies.

or you can also listen to the article here, listen through google podcast here, or apple podcast here.

This Stable Value Stock Is Built To Weather Market Storms

It is hard to say anything about McKesson that we have not said before — it is a high-quality business with extremely cheap shares.

The pharmaceutical distributor should earn around $15 in 2020 and will IPO its technology business, which will unlock another $20-30 of value. McKesson stock is not just cheap — it’s incredibly cheap. If we take the current $127 price and take out $25 for the technology business, we are paying about $100 for $15 of earnings — less than 7 times.

Each business has an internal business cycle. Sometimes it is linked to the economy — such businesses are usually called “cyclical.” Others have internal industry dynamics that have nothing to do with the economy.

McKesson, for example, benefited tremendously when billions of dollars worth of branded drugs lost their patents and went generic between 2009 and 2015.

This wave of profitability impacted McKesson shares. Increased profitability of generics brought new, smaller competition in the generics space, attracted by a larger profit pie. The competitive dynamics of drug distributors had not really changed much, but McKesson and other distributors were overearning — their margins were too high. Growing revenues and expanding margins resulted in tremendous earnings growth, which brought “growthy” investors into McKesson’s shareholder base. As the generics wave sagged, McKesson’s margins declined to their normal level and so did earnings. These new shareholders fled, driving the stock down.

Beats & Misses, Seen & Unseen

Wall Street glorifies companies that beat quarterly estimates by arguing that the long term comprises a lot of short terms. But beating earnings estimates for a few consecutive quarters doesn’t necessarily lead to long-term greatness. It assumes that significant changes to the business are visible in the reported numbers.

This is likely what General Electric executives rationalized as they destroyed the company’s protective shareholder “moat” and its respected corporate culture. Their short-term thinking focused on “beating earnings” on a quarterly basis, thereby insuring seemingly endless analyst upgrades. Except GE’s short-term success that was seen by the market came at the expense of unseen damage to its moat, balance sheet, and corporate culture.

Conversely, consider Apple reporting what analysts considered “disappointing” numbers for eight sequential quarters (three lifetimes on Wall Street) leading up to 2007. During that time, Apple is pouring every ounce of its resources into R&D and coming up with the iPhone. It cannot hire the right engineers fast enough and thus must pull in engineers who had been working on the Macintosh (then Apple’s bread and butter), which results in delaying the introduction of new computers by a few quarters (this did happen). Did those negative short-term results subtract from the value of the company, or were they instrumental in adding trillions of dollars of revenue to Apple?

#GE #AAPL

Resetting Defaults

What I am about to share with you is somewhat random drivel about a topic that has been very important to me in 2018 – time. I am anything but an expert on it; and in fact, as you’ll see, this is something I fail in and am trying to fail less.

I recently read Make Time, written by Jake Knapp and John Zeratsky, two ex-Google engineers who worked on Gmail and YouTube. The book is written by geeks for geeks like me (and probably the majority of my readers). Jake and John provide very insightful tips of how to “make time.” Also, they made me look at technology companies and time from a slightly different perspective.

Think about Proctor & Gamble, Hershey, Nestle – the old giants of the late 20th century. If you were an engineer or chemist working for one of those companies, you probably loved your job, creating products consumers were delighted to spend more and more money on. Be it instant coffee, TV dinners, or exotic things covered in chocolate. The more successful you were, the more of your company’s products consumers bought and thus the more dollars they spent.

But today, the majority of products sold by Silicon Valley companies like Facebook, Twitter, and Google are not sold in stores; and even more importantly, consumers don’t pay for them with dollars but rather with what is seemingly the cheapest commodity of all: time, which, ironically, is the scarcest commodity.

The Market Right Now Doesn’t Care How Fantastic Your Stocks Are

The Roman philosopher Seneca wasn’t talking about the stock market when he wrote that “Time discovers truth,” but he could have been. In the long run a stock price will reflect a company’s (true) intrinsic value. In the short run the pricing is basically random. Here are two real-life examples.

Let’s say you had the smarts to buy Microsoft in November 1992. It would have been a brilliant decision in the long run — the software giant’s stock has gone up manyfold since. But nine months later, in August 1993, that call did not look so brilliant: Microsoft shares had declined 25% in less than a year. In fact, it would have taken you 18 months, until May 1994, for this purchase to break even. Eighteen months of dumbness?

In the early 1990s, the PC industry was still in its infancy. Microsoft’s DOS and Windows operating systems were de facto standards. Outside of Apple Macs and a tiny fraction of computers, every computer came preinstalled with DOS and Windows. Microsoft had a pristine balance sheet and a brilliant co-founder and CEO in Bill Gates who would turn mountains upside-down to make sure the company succeeded. The above sentence is infested with hindsight — after all, that was almost 30 years ago. But Microsoft clearly had an incredible moat, which became wider with every new PC sold and every new software program written to run on Windows.

Here is another example: GoPro is a maker of video cameras used by surfers, skiers, and other extreme sports enthusiasts. If you had bought the stock soon after it went public, in 2014, you would have paid $40 a share for a $5.5 billion–market-cap company earning about $100 million a year — a price-earnings ratio of about 55. Your impatience would, however, have been rewarded: The stock more than doubled in just a few short months, hitting $90.

#microsoft #gopro

Why We Sold Apple Stock

Our firm bought Apple shares for clients’ portfolios in 2013, and we are used to being a contrarian voice when it comes to the stock (read here and here) — we loved it when it was hated. Now we are contrarian again — this time going against the company’s faithful.

Here are key reasons why we sold our entire Apple stake just last week:

The iPhone, though indispensable, is a mature product. Since introduction of the iPhone X, as been raising prices on iPhones. For instance, last quarter iPhone sales jumped 24% despite the number of iPhones sold not changing — all growth came from higher iPhone prices. Smartphone penetration is high globally, and thus most of the growth currently comes from replacement phones. Higher prices and lack of significant incremental improvements will likely lead to elongation of the replacement cycle from two years to three (or possibly four).

Recently Apple announced that it will stop disclosing iPhone and iPad shipments. There is only one way to read this news: The iPhone is a mature, middle-aged product with a wife and two kids. Apple’s management is desperately trying to create the narrative that it is becoming a service company. The second line of Apple’s quarterly press release says, “Services Revenue of $10 Billion Reaches New All-Time High.” Apple is trying to monetize its enormous installed base of iPhones, iPads, and Macs by selling digital goods and services to their owners.

Personal Musings, November 2018 Edition

I’ve never been to a TED Talk, though I’ve watched plenty of them. This week I am going to attend the TEDx Talks in Hickory, NC, organized by my friend Chris Pavese. I am extra-excited because my friend Roben Farzad will be one of the speakers.

Roben and I met in an interesting way.

My wife was born in Tajikistan – a former Soviet republic, now an independent country, bordering Afghanistan and China. Any Jewish family leaving the Soviet Union in the ’80s or early ’90s was officially considered a “refugee” family by the US government. Though my own family encountered occasional anti-Semitism in Russia and experienced at times the feeling of being second-hand citizens, we never had to fear for our lives. My wife’s family, on the other hand, were true refugees. One day she came to school to find a tank blocking the gate – the country was engulfed in civil war. That war lasted half a decade, and tens of thousands of people died in it. Luckily, my wife’s family was able to escape to America.

I was just a kid when my family immigrated to the US – I was full of excitement (energized by the American movies I’d watched) and hadn’t a worry in the world. Today, after having kids of my own, I can only imagine the sleepless nights my wife’s and my own parents endured. Arriving in a new, unknown country, you quickly discover that Americans don’t speak the Queen’s English, the language that was drummed into you in school. You get off the plane, and then what? You need an apartment, furniture, kids need to go to school. You have enough money for one trip to the grocery store (which by the way has more food than you’ve ever seen in your life). God forbid your kids get sick –then what?

The Average Stock Is Overvalued Somewhere Between Tremendously And Enormously

My business is to constantly look for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at the holdings of respected investors, talking to a large network of investment professionals, attending conferences, scouring through ideas published on value investor networks, and finally, scouring a large (and growing) watch list of companies to buy at a significant margin of safety.

With all of that, my firm is having little success finding solid companies at attractive valuations.

Don’t just take my word for it. Take a look at several charts, below, that show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued — somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, I don’t know either. But this is my point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

How A Stock Market Turns Investors Into Gamblers – Audio Edition

Today I am going to share with you an article I wrote after the January 2018 stock market volatility. It’s as relevant today as it was then. However, this time around you don’t have to strain your eyes; you can use your ears. Optimal Living Daily has turned my article into a podcast. Turn off your TV, shut down your brokerage website, relax.

My Self-Improvement Journey

I am 14 months into working on my new book, The Intellectual Investor, which is far from being finished. I have written fifty thousand words but have yet to find answers I am looking for, and thus the journey continues. Working on this book has been one of the most fulfilling experiences of my life. Because of it I am:

11 months into not eating dessert (read my “I Don’t Eat Desserts” article here)

6 months into working out twice a week with a trainer

5 months into not eating carbs – no more bread, potatoes, or rice

5 days into doing meditation.

Working on the book accidentally stirred up this whirlwind of self-improvement. Giving up desserts ended up dramatically improving my cholesterol. A few months later I got a trainer. Before then I had never worked out continuously for more than a month. Six months into working out, I feel differently. It is difficult to describe that sensation, but growing muscles provides physical fulfillment I did not know I was missing.

How To Invest In A Stock Market That’s Due For A Hard Landing

I simply don’t trust the fundamentals of the global economy right now. The system is built on quicksand.

Debt is growing globally and governments are running huge deficits while interest rates are still incredibly low. Looking at almost any metric, stock markets have been more expensive once in the last 100 years — just before the dot-com bubble burst. There is also another risk in a category of its own: China.

A recent Bloomberg report on Chinese real estate noted that from June 2015 through the end of last year, the 100 City Price Index, published by SouFun Holdings Ltd., rose 31% to almost $202 per square foot. That’s 38% higher than the median price per square foot in the U.S., where per-capita income is more than 700% greater than in China.

This China story gets more interesting. Most of these apartments are sitting empty because they are purchased as investments. Rental yields in China are 1.5%, while the cost of borrowing (mortgage cost) is around 5%-6%. Chinese consumer debt-to-GDP is much greater than it was in the U.S. during the 2008-09 financial crisis.

Investors Have Misdiagnosed Amazon’s Push Into The Pharmacy Business

Companies everywhere, in every business, are paranoid about Amazon.com. This sort of paranoia is healthy for the long-term well-being of our investment portfolio, as it is creating interesting buying opportunities.

A case in point: My firm spent a lot of time thinking about pharmacies when we were analyzing investments in McKesson and other drug distributors. We struggled with a question: How will the retail pharmaceutical industry look in the future? Or more precisely, how will Amazon’s entrance into the retail pharmacy business change this industry?

Our inability to answer this question kept us away from retail pharmacies. Then we had a small but important insight that shifted our thinking on Walgreens Boots Alliance. The preponderance of drugs in the U.S. is consumed by an older population, whose habits change slowly or not at all. Accordingly, it’s likely that Amazon’s online pharmacy will not significantly impact the existing drug industry.

Here’s why: Americans currently spend $450 billion a year on drugs. Walmart is the fourth-largest pharmacy in the U.S., with sales of $21 billion, or 4.6% of the company’s total sales. Let’s say that over the next five years Amazon gets to Walmart’s sales level of $21 billion. If the U.S. pharmaceutical industry grows 2% a year over that time, total drug sales will have increased by $45 billion, or the equivalent of two Walmarts (we are ignoring compounding here), to $495 billion. Walgreens, with its pharmacy selling about $70 billion a year, would barely notice Amazon’s presence.

Why My Firm Sold Short-Term Bond ETFs and Bought U.S. Treasury Bills

Recently my firm replaced all of our short-term bond exchange-traded funds with U.S. Treasury bills. The core motive for this decision was not to pick up a few points of extra yield, though that’s a nice bonus. We sold these ETFs because we were concerned about the low-probability but still possible risk mismatch in liquidity between the ETF and the securities it holds, in the event of a (not-low-probability) panic sell-off in the market.

Our problem with the ETFs concerned liquidity. Liquidity is measured on two dimensions, time and price — it is the degree to which an asset can be bought or sold without impacting its price. For instance, a house is not really a liquid asset. If you want to sell it fast you might have to lower the price significantly to find buyers. On the other hand, stocks of large companies and U.S. Treasury bills are incredibly liquid.

Yet this definition of liquidity is not complete. Liquidity of an asset may or may not be constant — it can change from one environment to another. Today, in a benign economic and market environment, many assets provide a false sense of liquidity. But this may change on a dime when this artificially created calm gets roiled.

Questions I'd be Asking If I Owned Tesla Stock

Here’s a big question I’d be asking if I owned Tesla stock: What happened to 345,000 reservations?

When Tesla’s Model 3 was released, it was supposed to be a $35,000 car. Four hundred thousand people, including yours truly, put down a $1,000 deposit to reserve their spots in line so they could get their hands on that marvel as soon as it became available. It was a brilliant move by Tesla, as it provided the company $400 million of interest-free financing — the biggest crowdfunding project ever.

Today, after some delays, the Model 3 is being produced. However, $35,000 seems to have been a fiction of CEO Elon Musk’s imagination. Though the car is getting great reviews from auto critics, the price for a bare-bones Model 3 starts at $49,000, and the tax incentives are fading away.

But something interesting happened recently. I received an email from Tesla that said: Model 3 is available to order, and no reservation is required in the U.S. We’re now offering all our best options — including our Long Range and Performance configurations with dual motor all-wheel drive. You can design and order yours today for delivery in approximately 2–4 months.

On the surface this sounds like great news, except that it begs a question: What happened to 345,000 orders? Let me explain. According to Bloomberg, which has been tracking Tesla’s production, to date (as of July 28, 2018) Tesla has produced 55,000 Model 3 cars. Since a $1,000 deposit was supposed to secure buyers a place in line, any car ordered today will only be delivered after orders that were placed years ago are fulfilled — after all, 400,000 people paid Tesla $1,000 to hold their places.

Thus there are only three possible explanations for the email I received. One is that Model 3 production is expected to accelerate at an exponential rate to 40,000 cars a week, starting now. However, Bloomberg estimates that Tesla’s normal production cadence of the Model 3 is closer to 2,825 cars a week, so this is a highly unlikely scenario.

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ValueX Vail Presentations

When I write about VALUEx Vail I always catch myself sounding just like Tim Cook: “This is the best iPhone ever!” As the iPhone incrementally improves every year, so does VALUEx Vail. We don’t put any incremental R&D into our private value investment conference, but it gets better for one simple reason: We all become closer and closer friends (we had only five new attendees out of 40 this year). We heard 30 presentations over three days. Some participants allowed us to post their presentations online, and you can view them here.

London Value Conference Presentation (Q&A)

I had the pleasure of speaking at the London Value Conference, which was a terrific, first-rate event. I did not make a formal presentation; instead I did Q&A with my friend, the wonderful David Shapiro.

On the morning of the conference (which happened to be midnight in Denver), I found I had a hard time waking up. I went for a long walk – it didn’t help. So I drank six cups of coffee, which did wake me up, eventually. But it also made me a bit jumpier than usual, so that I could not list all of the Six Commandments of Value Investing. But don’t you worry, we created an eight-part email series that walks you through them, or you can download our brochure and read them there.

You can watch Q&A session here.

I hope you enjoy it.

We are back from Laguna Beach. After every family vacation I ask myself what is the single most enduring memory I’m taking away from the trip. For me it was not Lego Land or whale watching, though both were a lot of fun. (Lego Land is, however, better for a four-year-old and doesn’t have much to offer for a 12- and a 17-year-old).

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Vitaliy Katsenelson