Archives For Shleifer Effect

Last February I got to hear John Mackey give a speech about a better way of doing business. He’s a founder and co-CEO of Whole Foods, and he stopped in at a Raleigh Chamber of Commerce event to promote his book, Conscious Capitalism: Liberating the Heroic Spirit of Business.

John Mackey, Whole Foods CEO Photo Source: Joe M500, Flickr (Creative Commons License)

John Mackey, Whole Foods CEO
Photo Source: Joe M500, Flickr (Creative Commons License)

The book’s premise flies in the face of Milton Friedman’s argument that the business of business is business. While Friedman makes the case that the only purpose of a business is to increase value for shareholders (i.e., maximize profits), John Mackey says its obligations are better understood as a balance among five groups of stakeholders:  stockholders, employees, customers, suppliers and the environment.

Mackey actually takes it one step further. He says companies that serve the interests of all the stakeholders have a competitive advantage. They create more value and are rewarded by the stock market.

After his speech I had the opportunity to ask Mackey a question. “If conscious capitalism is such a good thing,” I asked, “why aren’t more companies doing it?”

He responded by saying, in essence, that it just needed a vocabulary, someone to give it a voice, a demonstration to the world that it is a better way of doing business. “I’m giving all of you a secret formula for building a successful business,” he continued. “It will be copied as others see you succeed with it.”

Whole Foods is meant to be the living example of this better model.

Fast forward to this morning. I’m enjoying coffee with a friend at my local Whole Foods. It seems a good time to reflect on Mackey’s secret formula. Since last year the Whole Foods Market stock price has been cut almost in half, dropping from $65 per share to around $37. It’s been a rough ride. Continue Reading…

Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon’s current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market’s reaction…let’s just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo’s always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching – ever so briefly – its own 52-week high.

One of those important Wall Street metrics is eBay’s Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market’s logic…

Continue Reading…

In this my third reading of Taleb’s Fooled By Randomness in the past five years, my attention is drawn to a section he calls The Earnings Season: Fooled by the Results. Its description (below) is reminiscent of (or prescient of) the Shleifer Effect. It creates interesting questions about the model and how/whether it’s tied to randomness.

First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I’ve already conceded (here) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb’s book, I would assume his thoughts have influenced the Shleifer Effect as well.

From pages 164-5:

Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting – stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. 

Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 “star” companies showing an increase in profits (assuming no inflation), and 5,000 “dogs.” After three years, we will have 1,250 “stars.” The stock review committee at the investment house will give your broker their names as “strong buys.” He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.

Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book Inefficient Markets, Andrei Shleifer’s assumption seems to be that chance determines whether a company’s earnings go up or down. He does not concern himself with competitive advantages protecting profits. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter.  So it is chance.

I don’t think that’s his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.)  The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.

That’s Taleb’s point here, too. I think. He constructs his cohort of 10,000 companies that “engage in all forms of volatile business.” Perhaps I’m reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage.

Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer’s predicted overreaction. And it happens on the upside and the downside.

For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside…BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.

 

I’m catching up on some of my screens from last week, and I notice that Nike (NKE) took a big hit on news that it missed consensus earnings estimates by about 15 percent. The price dropped over nine percent on the news.

MarketWatch provides a news write-up here. Revenue was up 12 percent for last quarter, but earnings dropped about eight percent. Costs went up, the company increased marketing spending in preparation for the London Olympics, orders from China dropped quite a bit, and it reduced it earnings growth guidance for the year.

Here are some of the analyst quotes pulled from  MarketWatch article (mainly for entertainment purposes):

It’s “a rare miss for Nike,” said UBS analyst Michael Binetti, who added he’s “disheartened to hear” that the company’s gross-margin recovery will be pushed out again after three straight quarters of missing its own targets.

 

“Nike becomes a much trickier stock from here,” according to ISI Group analyst Omar Saad. Sales “may no longer be enough for investors to overlook the company’s perplexing ongoing margin pressure.” Saad also said the margin miss makes him “a little concerned that this highly sophisticated, dominant, global consumer company does not have as good a handle on its costs as one would hope.”

 

Nike is an incredible brand. An icon really. It’s down about 20 percent from its 52-week high, but that $115 price was being fueled by a lot of optimism. It’s now trading around 20x earnings trailing twelve month earnings. That’s not cheap unless we think those earnings are depressed for some reason. A quick view of Morningstar data shows that Nike is actually near an all time earnings  peak.

For now it’s on the watchlist, but I would want to see some more healthy pessimism behind this before saying it’s a prime Shleifer Opportunity.

God bless Henry Blodget and his Business Insider concept. He’s taken pieces from the Huffington Post and Gawker models and brought them to business media, a “journalism” market most would say is far too buttoned down for sensational style reporting.

Well, it turns out business readers are just as big of suckers for tabloid headlines as any other group. I count myself in there, too. I confess to being an avid (perhaps too avid) follower of all Blodget posts on Business Insider. I’m not ashamed of it. The dude is smart and occasionally very insightful. (Following him on Twitter, however, will exhaust you. He can give the best teenage gossip girls a run for their money.) The piece he wrote for New York Magazine about Mark Zuckerberg, The Maturation of the Billionaire Boy-Man, was an impressive specimen of long form journalism. And he went deep on analysis and commentary (here) of Zuckerberg’s letter to investors from Facebook’s S-1 filing, to the benefit of anyone interested in understanding the CEO’s motivations. Finally, he provided a sensible perspective on the whole sham of IPO pops with this article:  Everyone Who Thinks IPO “Pops” Are Good Has Been Brainwashed

But you must take Blodget’s approach with a grain (or two…or three) of salt. You must recognize that his purpose is to entertain as much (or more so) as it is to inform with a journalist’s rigor. Blodget’s job is to give his audience that fix of instant analysis, irrespective of whether the facts queue up in a straight line.

Since I bought shares of Facebook (write up here), I’ve been particularly interested in his coverage there.  It’s been a fun ride. Let’s do a quick re-cap…

The latest was this story from the afternoon (caps are his): GOOD NEWS FOR FACEBOOK: Big Advertiser Says Performance of New Mobile Ads Is Very Promising. A positive news story, of course. But it’s reversing course from his standing trend, as demonstrated by these headlines:

 

Blodget is a one man Shleifer Effect machine! In the course of a month he takes us from enthusiast to depressive and back again, spinning the story each time for maximum attention-grabbing affect. That’s his spiel, and I don’t fault him for it. But I do see his hyperactive approach as a microcosm for what traditional financial media does, just much slower turnaround. Blodget cycles from mania to depression a few times a day, eager for the clicks and agnostic to what might generate them. Traditional financial media works in slower waves, but they’re no less captivated by the prevailing mood and only slightly less eager to portray complex issues as absolutely bad or absolutely good.

 

I don’t believe Facebook requires much by way of introduction. I’m not sure history can show us a more heralded (by the media anyway) public offering fueled by tremendous optimism about the business only to be replaced within days by a string of bad news stories, leading to widespread pessimism about its future, and accompanied by a steep drop.

This is classic Shleifer Effect stuff. But it’s a different kind of business than ones I’m used to evaluating and owning…it’s a far cry from a value situation. This is classic big story growth stock. That’s why I have to disclose this confession: I bought a small piece of this business today.

I’m working on some other projects and don’t have the time to go into much detail right now, but I’ll try to get back to it soon.

Suffice it to say that I see a business with a lot of opportunity for growth by tapping an asset of enormous value, its user base. They make some money now, and I believe the company will find ways to squeeze something viable (nay, thriving) out of those 900 or so million users.

While I remain skittish of social networking businesses (see this post where I mention Facebook in reference to MySpace), I believe there is a durable competitive advantage. In other words, I don’t foresee (despite many people that believe differently) something like Twitter or an upstart making serious inroads to steal Facebook market share and/or force it into a pricing war that reduces its profitability.

I also believe it has a profitable economic model in that its gross margins can (and do) exceed its expense structure (and this despite a lot of expenses expanding for growth) and its earnings can (and do) exceed its requirements for reinvested capital.

But then there’s that pesky problem of price. When measuring it against earnings, it’s high. Very high. Even after the major fall. How am I rationalizing this to myself then, you must ask.

Pessimism. Tremendous, and I believe, unwarranted pessimism that is leading to irrational behavior. Granted, this same pessimism could burgeon further from here. My purchase might lose value. At this point, based on my evaluation of what I see, that would create another buying opportunity. I would take advantage of it.

So, I will no doubt inspire righteous ire by quoting Warren Buffett below in my justification for buying Facebook. But these models are complex and nuanced, so here is one upon which I’m depending more and more…

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

Most of the resources I’m paying attention to for news about Facebook come from Henry Blodget’s BusinessInsider.com. Again, I’m not actively trying to attract the outrage of my value investing compatriots, but I find a lot of signal inside the layer upon layer of noise that comes out of Business Insider.

Facebook Stock Is Breaking Down Again (May 30, 2012)

How Morgan Stanley Clients Got Screwed On Facebook — And How We Can Fix The System (May 31, 2012)

All eyes are on Facebook and CEO Mark Zuckerberg as the stock is scheduled to debut on the NYSE this Friday. They have lips flapping as pundits and gurus are shouting over each other to get their opinions noted on whether this business is worth your investment dollars. Allow me to add to the din by expanding on my previous post, Whom Does Management Serve?

Zuckerberg has garnered plenty of criticism for pocketing the majority of voting rights, ensuring that he will have total and complete control over every aspect of the business, not the least of which is strategic direction. And he’s not shy about saying has his own plans for the company which is likely to be at odds frequently with investors looking for financial results.

Facebook’s Registration Statement (filed in February with the SEC) contains a letter from Zuckerberg outlining his priorities. Some excerpts…

 

Facebook was not originally founded to be a company. We’ve always cared primarily about our social mission, the services we’re building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works…

Simply put: we don’t build services to make money; we make money to build better services. And we think this is a good way to build something…

These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.

By focusing on our mission and building great services, we believe we will create the most value for our shareholders and partners over the long term — and this in turn will enable us to keep attracting the best people and building more great services.

We don’t wake up in the morning with the primary goal of making money, but we understand that the best way to achieve our mission is to build a strong and valuable company. This is how we think about our IPO as well.

Here we have a CEO telling the world, in no uncertain terms, that maximizing profits is not his priority. He has a bigger and different vision for the world. As investors we should be aghast, right?

Before addressing that, let me admit that I have no idea what Facebook is worth as a business. It’s probably a fair amount, but my prevailing model used to understand social media companies is MySpace.  It was the pre-Facebook darling, beneficiary of young eyeballs and the power of the network effect. As such, it was scooped up by News Corp for a fat price. And shortly thereafter all the eyeballs left. Quickly and unceremoniously. That fickle bunch decided Facebook was the place to do all the stuff they had previously done on MySpace. And now MySpace is a shadow of its former self.

We’re assured that Facebook is superior, having solved all the problems that plagued MySpace and left subscribers willing to entertain an alternative. That would never happen to Facebook, we’re assured. Maybe. But I’m not comfortable with the possibility, and so it’s a clear pass for me.

That being said, I’ll confess the utmost admiration for the move Zuckerberg pulled to consolidate control. And if Facebook is going to live up to its potential, it will come at the hands of the founder. He has a vision for it that extends beyond share price. I think that’s essential for a business. They lose their soul when they get too eager to please shareholders.

If I could get pass the MySpace hang up, I would assess the following in determining if Facebook was a good investment…

First, is it participating in a large and/or growing market for the services it offers? I believe it probably is. It has a lot of room to add new users and expand the ways members utilize it today.

Second, does it have a profitable economic model? (i.e., Do its revenues exceeds its costs and expenses and can it produce earnings in excess of its costs of reinvested capital?) Most likely, yes. It’s profitable now, though throwing tons of cash back into growth. That user base must have some economic value, and the management minds at Facebook will likely discover the right method for tapping into it.

Third, does it have competitive advantages in place that protect its market share and margins from encroachment? That’s the part that I just don’t know, and I don’t think I could wrap my head around that issue even if I decided to spend a lot of time researching it.

If the answers to these questions were yes, and I believed Mark Zuckerberg had the ability to drive its success by focusing on the long-term value of Facebook as it serves as social connector for the world…but that in continuing to build it in that model, he was likely to face the ire of investors that would prefer profits now rather than wait…

Then I would celebrate Zuckerberg cornering control the way that he did. As a long-term investor, I would celebrate a CEO that openly denigrates profit decisions in favor of investing in the long-term competitive advantages of the business. And I would relish the fact that profit-takers would have no voice in the decisions guiding the business.

I would appreciate that the characteristics that make Facebook a franchise will be stronger five or ten years hence, and that I would therefore own a piece of a much more valuable pie.

But there are a lot of “ifs” to be satisfied first.

The Witch’s Dilemma

The witch gave the man two options. One, he could have a woman that, to him, would appear stunning. But the world would see her as ghastly. Or two, he could have a woman that, to him, appeared hideous. But to the world she would look beautiful.

So goes the dilemma from some fairy tale I recall from childhood, the source of which eludes my most diligent Wikipedia searches.  (If anyone remembers the title, please pass it along.)

Imagine yourself in a revealing moment of brutal honesty. Which option would you choose if the witch forced this decision on you? Switch the genders around if needs be, but be truthful.

I suspect most people would claim option one, confident in their ability to filter out the judgment of people around them. But I think they would be overestimating their capacity to be misunderstood. Disapproval and criticism from our family, friends, and colleagues has a withering affect on our psyches. Even if we put on confident airs, we shiver at the thought of others ridiculing our choices behind our backs. We want to be understood. We want our people to confirm our choices with their support. We want inclusion in the most desperate way.

And so I believe, despite our protests, the vast majority of us would select option two.

Yet there are those with the steely resolve to pull off option one. They are outliers. They have a tremendous capacity to be misunderstood.

Corporate CEO’s, the Capacity To Be Misunderstood, and Decision Making

I’d like to hire a social psychologist to visit the CEO’s of all publicly traded companies, administers the Witch’s Dilemma test in conjunction with a heavy dose of truth serum. I would ask her to use the responses to rate the individual executives’ capacity to be misunderstood. (Perhaps there are alternative questions we could devise that get to the heart of the matter. These CEO’s are emotionally intelligent folks. They didn’t get where they are without developing the ability to read into people’s intentions…the questions behind their questions.)  And I would compare that rating to the CEO’s track record of making bold (albeit sensible) long-term investments in the well-being of their businesses versus managing earnings to keep various constituencies content.

My suspicion is that those CEO’s that could be lumped in with option one (ugly wife) would correlate more closely with making better long-term decisions on behalf of their businesses. The other group would have a more difficult time departing from the expectations of their shareholders, employees, customers, family members, etc. Understandably so. It’s tough to do.

Getting to my point, when I see a business that combines some set of competitive advantages with the potential to grow and compound earnings, I want the leaders of that business to invest in that growth. This should go without saying, but very often it’s a difficult thing to do. Not so much because the operational expansion is daunting (though there is that part, too), but because the company must often take a winding path to secure that growth. It’s confusing. It changes things. It’s easy to misunderstand.

Let’s think a little about how a company grows. First, it must identify an opportunity to a.) expand its current offerings; b.) add new offerings; and/or c.) move offerings into new markets. In most cases, each option requires teams to make a judgment call. On the most fundamental level it is, can we execute that growth in a profitable way? In other words, will the added costs of increasing headcount, ramping up production, expanding infrastructure, investing in R&D, buying equipment, or marketing more aggressively…are these costs likely to succeed AND produce revenue in excess of costs and invested capital?

While executives can learn to mitigate risk (just as we do with investing), there is no crystal ball providing play-by-play of how the future will look. They must use their judgment. And investors hope they bring a certain amount of analytical rigor, management skill, experience-based intuition, and wisdom to the ways they spend the company money. In an ideal scenario, they possess a deep understanding of the strengths of their business – its advantages over the competition, barriers to entry, and moats – and know how to invest behind these strengths. (The better the strength, the easier the planning process!)

But there are no guarantees. Expansion is and always will be an exercise in predicting the future. It is about, after all, believing that additional supply you produce will be consumed by increased demand. A management team will try and fail. They MUST try and fail (at least occasionally) to test the limits of the business potential.

The most bold attempts to grow and compound earnings on behalf of investors – those investments with the greatest possibility for outsized rewards – do not happen in short time frames. They require big investments over long horizons with the real possibility of depressed earnings over the ramp-up period.

This enervates holders of the company’s stock – investors, employees, the CEO, his/her family. While all of them will say they want the earning to grow, each group tends to be averse to the risk and time required to make that happen. If you were to provide them with a slight bump in their dividend payout versus putting the same amount of cash into investments that have a high likelihood of paying out a nice return in, say, five years (but impair earnings growth in the meantime), far too many will forego a better payday for the feel-good immediate gratification.

Worst yet, if the investments are made in growth, they depress earnings for multiple periods, and the market has trouble understanding how and/or when the investments will pay off, the stock price will feel that misunderstanding.

And this is where the CEO’s decision making becomes hard. He must choose between investing in the long-term prospects of the business, a move that will impact earnings next quarter and bring the ire of Wall Street.   Or he can punt. Making timid investment choices; managing the earnings by looking first at whether the next statement will satisfy analyst expectations for the company’s performance. And then deciding how much more to allocate to investment in the company’s future.

If he invests for the future and is misunderstood, the move will generate a share price drop. And a lot of people are affected by the stock dropping. People that are important to the CEO. People he must see everyday. People who influence his life; that invested in no small part because they believed in him.

Back To the Witch’s Dilemma 

So here the CEO is playing out the Witch’s Dilemma. If he goes with option one – investing in the future of the business that impacts short-term results…the woman that looks pretty to him, but ugly to the world – the share price will be hammered. He will be misunderstood. People who have invested with him will be disappointed. They will feel less wealthy as a consequence of his decisions.

And all CEO’s know that if they get labeled with the dreaded letter “U” (Underperformance), many of the constituents they disappointed, along with a new slate of activist investors, will turn up the heat. They will make noise and start demanding change. The pressure will be enormous.

The CEO asks himself…will I even be around long enough to see these bold investments come to fruition? Or will my board bend to the discontented swarm and show me the door?

Being misunderstood is very hard on a person.

Allow me this aside about the concept of learned helplessness…

The psychic punishment of being misunderstood conjures memories of “learned helplessness” a concept belonging to psychology and the term being coined by Dr. Martin Seligman in the late-1960s.

Seligman ran a research lab at Cornell University and spent much of his time experimenting with lab rats. In one particular and somewhat cruel study, he placed a lab rat in a specially constructed box, repeatedly rang a bell, and followed the sound with a mild electric shock. The rat quickly learned to anticipate the shock when he heard the bell. As you can imagine, the rat would become frantic at the sound, running around his box in a futile attempt to avoid the discomfort.

It took very few rounds of this “bell-plus-shock” routine before the rat’s behavior changed. The bell still evoked agitation, but once he resigned himself that he had no control to stop the shock, the rat basically gave up and took it.

This observation led Dr. Seligman to his theory of learned helplessness, a phenomenon as easily applied to humans as rats. When faced with stressors most humans – including powerful CEO’s – that perceive they lack the control to resolve or avoid it end up sucking it up and going with the flow.

And so most CEO’s elect to avoid the discomfort of being misunderstood (if not fired) and choose the Witch’s option two. Even though they know the investments will pay off for long-term shareholders, that they will enhance the firm’s competitive advantages, that they will compound its earnings…the vast majority of CEO’s swallow hard and go with the woman that looks beautiful to the world but that they recognize as unattractive and unsavory.

***

Anyone For Investing In a Car Periscope?

I’ll conclude with a light-hearted parallel…

Season eight of HBO’s Curb Your Enthusiasm highlights this dilemma in an episode called Car Periscope. By way of quick summary,  Larry David and his agent Jeff are weighing an investment with an inventor of a device you snake above your sunroof in traffic jams to see the source of the slowdown and review your options for getting out quickly.

It’s a terrible concept, clearly, and the two are ready to decline the investment opportunity. But they meet the inventor’s wife and are struck by the disconnect. She is somewhat homely while the inventor is a decent looking guy. Larry is unabashedly shallow. He always wants the younger more attractive woman. It’s foreign to him  that a man would ever choose anything less; that someone would subject himself to the ridicule of the guys. This inventor is an outlier. He sees something in his wife that others don’t, and he possesses the capacity to be misunderstood.  Surely this belies some deep-seeded virtue in this inventor. In Larry’s logic, if he has the qualities that permit him to be comfortable and confident with the less attractive girl, perhaps he possesses the tenacity required of an inventor and businessman.

Hijinks ensue. The investment falls through, but Larry believes he has found a new model for gauging the character of men. He meets with his investment manager and, upon seeing a photo of his gorgeous wife, fires him. He selects another adviser on the sole basis of his plain-looking spouse.

This week I’ve been a bit obsessed with the idea that the manager’s job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet:

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors’ interests on their minds, remaining on constant look out for ways to increase shareholder value.

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business’ success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees.

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don’t align?

As a frequent visitor of Charleston, South Carolina, I’ve been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel.

The Citadel, a military prep college in Charleston, is hard on its first year students (called “Knobs”), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he’s supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school’s creed.

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It’s simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it’s unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters.

What’s a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor…that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line.

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers.

I’ll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham’s bi-polar Mr. Market, Sir John Templeton’s suggestion to buy when there’s blood in the streets, and even from Joel Greenblatt’s magic formula for spotting strong businesses that are out of favor.

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It’s a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It’s an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn’t mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you’ll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news.

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We’re looking for companies operating good businesses that happen to be misunderstood or unpopular.

There is no extra credit for being contrarian. You must be right!

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

I’ve been thinking a lot about Amazon.com lately. The business is in an interesting place. 

Few would argue against it being the dominant web retailer (let’s call this Amazon’s Business One), a market which provides plenty of runway to grow by expanding into new product lines and new geographies. Few would argue that its competitive advantages in web retail are not pronounced and formidable. 

Yet a huge chunk of its revenue comes from media (Amazon’s Business Two). Indeed, books and music and video and games, these provided the foundation for Amazon as a fledgling business and still (for 2011 at least) account for nearly 40 percent of sales.  The manner in which each of these products is consumed (and sold) is in major flux, transitioning from tangible inventory to digital formats. Where does Amazon fit in the world of digital media? Can it manage the cannibalization of its strength in the domain of physical media and segue into digital?

And now a growing chunk of its expense structure is devoted to a relatively new business, Amazon Web  Services (AWS/Cloud Computing…Business Three), which seems to produce paltry revenue compared to the resources the company throws its way.  At least for today.  Amazon is convinced that cloud computing represents tremendous growth potential and that it’s a market whose economics lend themselves to one of the company’s strengths…namely, the capacity to drive high volume through low margins to earn nice cash returns. Amazon believes it can dominate this market.

*****

In 2011, Amazon’s revenue grew $13.8 billion over the previous year while operating expenses grew $14.4 billion. Management is plowing cash back into all three of the businesses.  As a result, net income dropped in half. 

For most of 2011 Amazon was riding a multi-year wave of do-no-wrong sentiment from investors. Since 2006, revenue grew from $10.7 billion to over $48 billion. The business was stringing together five consecutive years of EPS growth, an increase of more than 5x from 2006 through 2010.  Media coverage was effusive in its praise; the story was a good one. The stock price soared from $38 at the end of 2006 to a high of $246 last October as investors were rubbing their palms together in eager anticipation of a trend line pointing forever north-by-northeast. 

Now Amazon was not necessarily cultivating this investor mentality. By most accounts, CEO Jeff Bezos is inclined to take a stoic view of the stock price, abiding to his long-term goal of building an enduring franchise and leaning into investments today to achieve market dominance tomorrow.

But as the Shleifer Effect teaches us, investors have a tendency to get excited by what they perceive to be a trend, and five straight years of EPS growth taps into that tendency to generalize a trend far into the future.

Here is the progression of headlines from the previous five quarters:

 

The Shleifer Effect suggests that a few tenets of behavioral finance might be in play here. First is the representativeness heuristic.  Investors get so excited about the uninterrupted revenue and EPS growth between 2006 and 2010 that they infer a growth trend that will continue. They conclude that it’s worth paying a premium for Amazon shares, and over time the share price grows from $38 to $246.

The second is the conservatism heuristic. The idea of the trend is set in the mind of owners of the stock and the idea has been reinforced with impressive performance quarter over quarter. Now they run into the first signs of evidence to the contrary.  What do they do? Nothing. They are defensive in their views. They aren’t going to change their minds at the first sign of storm clouds. So, even as Amazon guides toward lower earnings quarter after quarter, they hold steady. They keep their wits about them and perhaps even buy more shares. The stock price actually hits all time highs despite reduced EPS and guidance suggesting lower earnings to come.

The third part of the Shleifer Effect now comes with overreaction. After two or three consecutive quarters of guidance toward lower EPS, shareholders begin changing their minds. They see net profit cut in half from 2010 to 2011 and they lose their resolve. They begin subscribing to a new representative heuristic, i.e. after several consecutive quarters of declining performance, the new trend must have a down slope. Sell! The stock price ultimately falls to a multi-year low.  

When observers begin to believe a new down-slope trend has set in, the long knives come out. A company and its executives can quickly fall from media grace. One day all stories are written to extol their virtues, the strength of their business, the genius of their vision, the wisdom of their philosophy. And the next day, a barrage of criticism roles out…

In February, Barron’s says It’s Time to Rein In Bezos

The blogs call Amazon a “secular short,” calling out initiatives to grow market share (like Amazon Prime) and doubting the strategy of making investments in the expense structure in anticipation of growth.  

Others note the exodus of guru investors like George Soros and Julian Robertson. 

*****

So, back to my opening point: Amazon is in an interesting place. For five years it showed the world an ability to grow sales at a blistering pace without much damage to EPS. In 2011, that has changed. On the surface it would seem that Amazon believes it can accelerate investments now to solidify its place as market leader in web retailing, digital media, and cloud computing.  And it’s very willing to sacrifice quarter-to-quarter results by leaning hard into these investments. 

All investors, existing and prospective, should be on the edge of their seats to see how this plays out. 

On the one hand,  there is reason to believe Amazon is preparing to take its current owners on a bumpy ride by going all in with Amazon Prime (shipping subsidies and freeby services like streaming movies), Kindle devices, and building a bigger-better-cheaper AWS. EPS are very, very likely to suffer. Current owners must develop a steely resolve and recognize this will be turbulent. The Shleifer Effect is in play.

On the other hand, it’s not a stretch to interpret these investments as bets with pretty decent odds behind them. They have the hallmark of informed managers investing in their moat…recognizing their competitive advantages and spending heavily in their defense. Sure, that will lead to a short- or mid-term reduction in earnings, but it should create significantly more value over the long-term. 

Next, I want to explore whether it makes sense to forego those profits today for the possibility of even greater profits down the road.

In valuing Aeropostale in the previous post, we built an ugly scenario that assumed ARO’s operating performance deteriorated significantly. I suggested that, were this to occur, the market would punish the shares through a broad sell-off that could easily push its price down by 50 to 60 percent from the current $18 level.

This is pretty much what happened in October 2011. After years of growing same store sales quarter after quarter in an unblemished winning streak, ARO went into a slide for several consecutive periods. Same store sales were declining, inventory wasn’t moving, gross margins were taking a hit, and it was clear that another winning streak was at risk…growth in earnings per share.

 Investors stuck with ARO through the first couple misses. Management deserved some leash, they had demonstrated a lot of success with this business model over the years. But from the spring of 2011 through the autumn, the one-time darling was quickly becoming a toad. The stock price plummeted from $26 per share to a multi-year low of $9.16. Even the most stalwart supporters were losing their resolve – irrespective of their views of the long-term business prospects – as they saw their holding value collapse by two-thirds. While they may have reached the same conclusions about the business as I did in my original post (here), few could stomach being part of a quick fall and then trudge through a recovery that would likely take many quarters if not years.

For a construct to understand the dynamics of that sell-off, and the resulting opportunity to buy into a good business at a cheap price, I turn to the field of behavioral finance and Harvard economist  Andre Shleifer.

In his book Inefficient Markets: An Introduction to Behavioral Finance, Shleifer builds on the work of Robert Shiller and Richard Thaler, pioneers in this burgeoning field that blends theory from economics and psychology.

As we discussed previously, Professor Andrei Shleifer’s Inefficient Markets provides an instructive lens for viewing the past year or so of Aeropostale’s business operations and ensuing price volatility.

In short, investors watch a business, evaluate its performance, and form an opinion that tends to extrapolate its recent performance into the future. This tendency is called representativeness.

Once they form an opinion, they stick with it even in the face of disconfirming evidence. This is called conservativeness, and it remains the case until multiple pieces of evidence finally overwhelm them and force a change of mind. Investors then fall prey to overreaction – classic Mr. Market – getting overly excited about a company or depressed about it and pushing its price up or down (whichever the news may warrant.)

The concept passes my reasonable man test for how people (I’ll include investors in this category) behave, and so I’ll graft it on top of what we’ve observed with ARO to see what we can learn.

First, let me step back a little for an aside (albeit a long one) that I think drives home the point. A few months ago I watched a re-broadcast of the Fourth Annual Pershing Square Challenge at Columbia Business School. It took place in April 2011 and features teams of business student presenting their best investment ideas to Bill Ackman and a panel of judges. (Thanks to Value Walk for posting the video. You can access it here.)

In the last post we looked at several assumptions that, when accepted as more-likely-than-not correct, paint a picture of Aeropostale as a business with a market that’s not going away and seems to benefit from barriers that would prevent competitors from encroaching. On those fronts, it shows real promise as an investment opportunity.

Now I want to look at a few scenarios for thinking through its value. When we initiated our ownership position in late-October, ARO was trading just below $14 per share. Today it’s nearer to $18, and we’ll use the more current price in considering a range for its intrinsic value.

For the following, we’ll use these given assumptions:

1. ARO has 4.2 million square feet of retail space across its store base,

2. It will be taxed at 40 percent of operating income,

3. It has about 82 million shares outstanding, and

4. Its current share price is $18.

Now, let’s plug in some variables to see how the business looks on a price-to-value basis.

Scenario I: Ugly Forecast   

Here we assume that ARO continues taking a licking. Sales drop 20 percent from its 2010 high of $626 per square foot. Gross margins match the lowest of the previous ten years. And SG&A expense are the highest in ten years.

We started building a position in Aeropostale in late-October but I’m just getting around to writing about it now as I’m revisiting the thesis and thinking through potential risks. Let’s just jump in…

Assumption 1: The Mall Continues to Deliver Captive Market of Teenage Consumers

The mall is now and will remain fertile sales territory for retailers peddling wares to teenagers. While the traffic counts might ebb and flow a bit, these temples for commerce seem to have staying power with the teen demographic. In short, we assume they will continue going to malls and doing so with varying amounts of cash in their pockets.

Assumption 2: Mall-Based “Value” for Teen Clothing is a Distinct Market Niche

There is (and will continue to be) an important role for the value option for clothes in the mall. Indeed, it is a distinct market niche – as compared to full-price teen clothing retailing or value options outside of the mall – with its own set of unique properties and dynamics to consider.

Continue Reading…