Employees restock shelves of school supplies at a Walmart Stores Inc. location in Burbank, CA. Bloomberg
Last week there was a lot of stock market excitement regarding WalMart
. After a “favorable” earnings report analysts turned bullish and the stock jumped 4% in one day
, WMT’s biggest rally in over a year, making it a big short-term winner. But the leadership signals indicate WalMart is probably not the best place to put your money.
WalMart has limited growth plans
WalMart is growing about 3%/year. But leadership acknowledged it was not growing its traditional business in the USA, and only has plans to open 25 stores in the next year. It hopes to add about 225 internationally, predominantly in Mexico and China, but unfortunately those markets have been tough places for WalMart to grow share and make profits. And the company has been plagued with bribery scandals, particularly in Mexico.
And, while WalMart touts its 40%+ growth rate on-line, margins online (including the free delivery offer) are even lower than in the traditional Wal-Mart stores, causing the company’s gross margin percentage to decline. The $11.5 billion on-line revenue projection for next year is up, but it is 2.5% of Walmart’s total, and a mere 7-8% of Amazon’s retail sales. Amazon remains the clear leader, with 62% of U.S. households having visited the company in the second quarter. And it is not a good sign that WalMart’s greatest on-line growth is in groceries, which amount to 26% of on-line salesalready. WalMart is investing in 1,000 additional at-store curb-side grocery pick-uplocations, but this effort to defend traditional store sales is in the products where margins are clearly the lowest, and possibly nonexistent.
It is not clear that WalMart has a strategy for competing in a shrinking traditional brick-and-mortar market where Costco, Target, Dollar General, et.al. are fighting for every dollar. And it is not clear WalMart can make much difference in Amazon’s giant on-line market lead. Meanwhile, Amazon continues to grow in valuation with very low profits, even as it grows its presence in groceries with the Whole Foods acquisition. In the 17 months from May 10, 2016 through October 10, 2017 WalMart’s market cap grew by $24 billion (10%,) while Amazon’s grew by $174 billion (57%.)
Even after recent gains for WalMart, its market capitalization remains only 53% of its much smaller on-line competitor. This creates a very difficult pricing problem for WalMart if it has to make traditional margins in order to keep analysts, and investors, happy.
Leadership is not investing to compete, but rather cashing out the business
To understand just how bad this growth problem is, investors should take a look at where WalMart has been spending its cash. It has not been investing in growing stores, growing sales per store, nor really even growing the on-line business. From 2007-2016 WalMart spent a whopping $67.3 billion in share buybacks. That is over 20 times what it spent on Jet.com. And it was 45% of total profits during that timeframe. Additionally WalMart paid out $51.2 billion in dividends, which amounted to 34% of profits. Altogether that is $118.5 billion returned to shareholders in the last decade. And a staggering 79% of profits. It shows that WalMart is really not investing in its future, but rather cashing out the company by returning money to shareholders.
So very large investors, who control huge voting blocks, recognize that things are not going well at WalMart. But, because of the enormity of the share buybacks, the Walton family now controls over half of WalMart stock. That makes it tough for an activist to threaten shaking up the company, and lets the Waltons determine the company’s future.
Buybacks signal Strategy
There will be marginal enhancements. But the vast majority of the money is being returned to them, via $20 billion in share repurchases and $1.5 billion in cash dividends annually.
Amazon spends nothing on share repurchases. Nor does it distribute cash to shareholders via dividends. Amazon’s largest shareholder, Jeff Bezos, invests all the company money in new growth opportunities. These nearly cover the retail landscape, and increasingly are in other growth markets like cloud services, software-as-a-service and entertainment. Comparing the owners of these companies, quite clearly Bezos has faith in Amazon’s ability to invest money for profitable future growth. But the Waltons are far less certain about the future success of WalMart, so they are pulling their money off the table, allowing investors to put their money in ventures outside WalMart.
Investing your money, do you think it is better to invest where the owner believes in the future of his company?
Or where the owners are cashing out?
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Toys R Us filed for bankruptcy this week. And the obvious response was “another retailer slaughtered by Amazon and on-line retailing.” But this conclusion comes short of describing why Toys R Us leadership did not do the obvious things to keep Toys R Us relevant.
Amazon and WalMart both eclipsed Toys R Us in toy retail sales.
Chart courtesy of Felix Richter, Statista
Everyone, and I mean everyone, knew over the last decade that customers were buying more stuff on-line, including toys. And everyone also knew that WalMart was pushing extremely hard to keep customers going to their stores by offering products like toys at low prices. And, it was clear that customers were shifting to buying more toys from both these retailers. If this was so obvious to everyone, why didn’t Toys R Us leadership do something? After all, Toys R Us is a multi-billion dollar revenue company.
It was over 30 years ago when financiers discovered they could buy a company, sell off some assets and otherwise increase the company’s cash, then convince banks and bondholders to load the company with debt. These financiers would then pull out the cash for themselves, and leave the company with a ton of debt. The LBO (leveraged buy out) was born, invented by investment bankers like KKR (named for founders Kohlberg, Kravis & Roberts.) They would use a small bit of private equity, and then use the company’s own assets to raise debt money (leverage) to buy the company. By “restructuring” the company to a lower cost of operations, usually with draconian reductions, they would increase cash flow to make higher debt repayments. Then they would either take the money out directly, or take the company public where they could sell their shares, and make themselves rich. This form of deal making birthed what we now call the Private Equity business.
In 2005, KKR and Bain Capital (which included former Presidential candidate Mitt Romney) bought Toys R Us for about $6.6billion, plus assuming just under $1B of debt, for a total valuation of $7.5billion. But the private equity guys didn’t buy the company with equity. They only put in $1.3billion, and used the company’s assets to raise $5.3billion in additional debt, making total debt a whopping $6.2B. Total debt was now a remarkable 82.7% of total capital! At the time of the deal interest rates on that debt were around 7.25%, creating a cash outflow of $450million/year just to pay interest on the loans. At the time Toys R Us was barely making a profit of 2% – so the debt was double company net profits.
Debt led to bad management decisions and ultimately bankruptcy of the U.S. company
The biggest assumption behind a debt-financed takeover is that the company can cut costs to improve cash flow and thus pay the interest. But behind that assumption is an even bigger assumption. That the marketplace won’t change dramatically. The KKR and Bain Capital leaders assumed they could shrink Toys R Us in a way that would lower operating costs. They also assumed they could sell some under-utilized assets to raise cash. They did not assume they would need contingency money if competition, and the marketplace, changed in some unplanned way.
eCommerce was pretty new in 2005. Amazon was an $8.5 billion company, but it didn’t make any profits and very few predicted then it would become today’s $100 billion behemoth. Because the financiers didn’t anticipate a big market shift to ecommerce, they focused on the war with Walmart and Target. Their plans were to lower operating costs, close some stores that were underperforming, license some offshore stores, and sell some assets (like real estate owned or leases) to raise cash and repay the debt.
But they weren’t prepared to take on another, entirely different competitor on-line. As Amazon’s growth affected all retailers, Toys R Us simply did not have the resources to fight the traditional discount and dollar brick-and-mortar retailers, and build a major on-line presence, and keep paying that debt. While it is easy to sit on the sidelines and say that Toys R Us should have spent more money building its on-line presence in order to remain relevant, the fact is that the deal in 2005 left the company with insufficient cash flow to do so. Regardless of what leadership might have wanted to do, simply keeping the lights on was a tough challenge when having to pay out so much cash to bondholders.
And the investors simply did not expect that the growth of on-line retailing would stall traditional retail stores, thus creating a major loss of value for retail real estate. U.S. retail real estate value had increased in value for decades. The assumption was that the real estate, whether owned or leased, would continue to go up in value. Real estate was a “hard” asset that KKR and Bain Capital could bank on for raising cash to repay the debt. But as on-line retail grew, and traditional retail declined, America became “over stored” with far too much retail space. Prices were shattered in many markets, and it was not possible for Toys R Us to sell those assets for a gain that would meet the debt obligations.
With $400 million of debt coming due next year, Toys R Us simply doesn’t have the cash flow, or assets, to repay those bondholders
Old assumptions about finance are a big problem for companies today. Assumptions about “leveraging” hard assets, and intangibles like brand value, are no longer true. Competitors emerge, markets change, and old assets can lose value very fast. Assumptions about business model stability are no longer true, as new competitors using newer technology create new ways to sell, and often at lower cost than was ever expected. Assumptions about customer loyalty, and market share stability, are no longer true as new competitors appeal to customers differently and cause big shifts in buying behavior very fast. The speed with which technology, competitors, markets and customers shift now requires companies have the funds available to invest in change.
This story isn’t just about debt. The very popular activity of “returning money to shareholders by repurchasing stock” is a terrible idea. Stock repurchases do not make a company more valuable, nor a stronger competitor. Instead they burn through cash to reduce the company’s capitalization, and manipulate ratios like EPS (earnings per share) and P/E (price/earnings) multiple. Stock repurchases hurt companies, and make them less competitive. Good companies return money to shareholders by investing in growth, which raises sales, profits and increases the stock price making the company truly more valuable.
Toys R Us isn’t a story about Amazon, or eCommerce, taking out another retailer
Toys R Us isn’t a story about Amazon, or eCommerce, taking out another retailer
The important part of the Toys R Us story is realizing that the wrong financial decisions can doom your organization. You can have a great vision, and even great ideas about new ways to compete. But if you don’t have the money to invest in growth, it won’t happen. If leaders don’t have the money to spend on new projects and new markets, because they’re sending it all to bondholders or using it to repurchase shares in hopes of propping up a stock price, eventually there will be a market shift that will doom the old business model and leave it unable to compete.
To succeed today leaders need the money to invest in change, and they have to constantly invest it in change, or their companies will lose relevancy and end up like Toys R Us, Radio Shack, Circuit City, Aeropostale, The Limited, Payless Shoes, Gander Mountain, Golfsmith, Sports Authority, Borders Books and the great, original American retailer A&P.
Amid all the political news last week it was easy to miss announcements in the business world. Especially one that was relatively small, like Starbucks announcement on Thursday July 27, 2017 that it was closing all 379 of its Teavana stores. While these will be missed by some product fanatics, the decision is almost immaterial given that these units represent only about 3% of Starbucks US stores, and about 1.5% of the 25,000 Starbucks globally.
Yet, closing Teavana is a telltale sign of concern for Starbucks investors.
Starbucks founding CEO Howard Schultz returned to the top job in January, 2008, promising to get out of distractions such as music production, movie production, internet sales, grocery products, liquor products and even in-store food sales in order to return the company to its “core” coffee business. Since then Starbucks valuation has risen some 5.5-6 fold, from $9.45/share to the recent range of $54 to $60 per share. A much better return than the roughly doubling of the Dow Jones Industrial Average over the same timeframe.
Yet, one should take time to evaluate what this closing means for the long-term future of Starbucks. This is the second time Starbucks made an acquisition only to shut it down. In 2015 Starbucks closed all 23 La Boulange bakery cafes, with little fanfare. Now, after paying $620M to buy Teavana in 2012, they are closing all those stores. While leadership blamed its decision on declining mall visits (undoubtedly a fact) for the closures, Teavana is not missing goals due to the Amazon Effect. There are multiple options for how to market Teavana’s fresh and packaged products far beyond mall store locations. Choosing to close all stores indicates leadership has minimal interest in the brand.
Starbucks’ focus leaves little opportunity for new growth
It increasingly appears that today’s Starbucks literally isn’t interested, or able, to do anything other than build, and operate, more Starbucks stores. And Starbucks is clearly doubling down on its plans to be Starbucks store-centric. The company opened 575 new units in the last year, and announced plans to open more stores creating 68,000 additional US jobs in the next 5 years. Further, Starbucks is paying $1.3B to buy the half of its China business previously owned by a partner. Clearly, leadership continues to tighten company focus on the “core” coffee store business for the future.
This sounds great short-term, given how well things have gone the last 8 years. But there are concerns. Sales are up 4% last quarter, but that is wholly based upon higher prices. Customer counts are flat, indicating that stores are not attracting new customers from competitors. Sales gains are due to average ticket prices increasing 5%, which is marginal and likely refers to higher priced products. Starbucks is now relying completely on new stores to create incremental growth, since bringing in new customers to existing stores is not happening.
Frequently this stagnant store sales metric indicates store saturation. A bad sign. Does the US, or international markets, really need more, new Starbucks stores? It was 2010 when comedian Lewis Black had a successful viral rant (PG version) claiming that when he observed a Starbucks across the street from another Starbucks he knew it was the end of civilization.
What happens when the market doesn’t need new Starbucks stores?
One does have to wonder when the maximum number of Starbucks will be reached. Especially given the ever growing number of competitors in all markets. Direct competitors such as Caribou Coffee, The Coffee Bean, Seattle’s Best, Gloria Jean’s, Costa, Lavazza, Tully’s, Peet’s and literally dozens of chain and independent coffee shops are competing for Starbucks’ customers. Simultaneously competition from low priced alternatives is emerging from brands like Dunkin Donuts and McDonald’s, now catering more to coffee lovers. And non-coffee fast casual shops are seeking to attract more people for congregating, such as Panera, Fuddruckers, Pei Wei, TGI Friday’s and others. All of these are competitors, either directly or indirectly, for the customer dollars sought by Starbucks. Are more Starbucks stores going to succeed?
As McDonald’s, Pizza Hut and other fast food chains learned the hard way, there comes a time when a brand has built all the market needs. Then leadership has to figure out how to do something else. McDonald’s invested heavily in Boston Market and Chipotle’s, but let those high growth operations go when it decided to refocus on its “core” hamburger business – leading to heavy valuation declines. Starbucks is closing Teavana, but should it? When will Starbucks saturate? And what will Starbucks do to grow when that happens?
Starbucks has had a great run. And that run appears not fully over. But long-term investors have reason to worry.
Is it smart to make such a huge bet on China?
Will store growth successfully continue, with all the stores that already exist?
Will direct and indirect competitors eat away at market share?
What will Starbucks do when it has reached it market maximum, and it doesn’t seem to have any emerging new store concepts to build upon?
Writing on trends, I frequently profile tech companies that use trends to outperform competitors. But using trends is not restricted to tech companies.
By following trends, since 1998 Alexandria Real Estate Equities has tripled the performance of the NASDAQ, quadrupled returns of the S&P 500, and quintupled the Russell 2000. Alexandria has even outperformed technology stalwart Microsoft, and investment guru Berkshire Hathaway by 230%.
Although you probably never heard of it, Alexandria has trounced its real estate peers. Over the last three years Alexandria has returned double the FTSE NAREIT Equity Office Index, and double the SNL US REIT Office Index. Alexandria’s value has almost doubled during this time, and produced returns 2.3 times better than such well known competitors as Vornado Realty Trust and Boston Properties.
In 1983, Joel Marcus was a lawyer in the IPO market when he noticed the high value launch of biotech firms like Amgen and Genentech. He began tracking the growth of biotechs to see what kind of opportunity might appear to serve these high growth companies.
By 1994 Marcus realized that these companies were struggling to find appropriate real estate to serve their unique needs for laboratory space, and the infrastructure these labs require. It was a classic under-served market, and it was growing fast.
Jacobs Engineering (NYSE:JEC) was serving some of these companies’ needs, including erecting structures for them. But Jacobs did not own any buildings or consider itself a real estate developer. So Marcus approached Jacobs about starting a company to meet the real estate needs of this high growth biotech industry. Marcus put up some money, Jacobs put up some money, and other friends/associates combined to raise $19 million. There was no professionally managed money involved – and no real estate developers.
Focusing on the rapidly expanding biotech scene in San Diego, the newly created Alexandria bought 4 buildings. They refocused the buildings on the unserved needs of local biotech companies and did a quick flip, breaking even on the transaction. With just a bit of money Alexandria had proven that the market existed, the trend was real and users were under-served.
But, like any idea based on an emerging trend, growing was not easy. Using their first transaction as “proof of concept” CEO Marcus and his team set out to raise $100 million. Quickly Paine Webber (now UBS) secured $75 million in debt financing. But moving forward required raising $25 million in equity.
Over the next few weeks Alexandria pitched a slew of nay-sayers. From GE Capital to CALPERS investors felt that their first deal was a “1-trick pony,” and this “niche market” was not a sustainable business. Finally, after 29 failed pitches, the AEW pension fund, an early stage real estate investor, saw the trend and invested.
The Alexandria team realized that fast client growth meant there was no time to develop from ground up. They focused on high growth geographies for biotech, places where the trend was more pronounced, and bought 11 existing properties:
- In Seattle they found a cancer center they could buy, improve and do a sale-leaseback
- In San Francisco they identified a portfolio of properties in Alameda they could improve, lease to biotech companies and even suit the needs of the FDA as a tenant
- In Maryland they identified opportunities to support the lab needs of the Army Corps of Engineers forensic research lab, and ATF testing lab for imported vodka, and a medical testing lab near Dulles – which is now leased to Quest Diagnostics
Realizing that companies needing labs tended to cluster, leadership focused on finding locations where clusters were likely to emerge. They bought land in San Francisco, San Diego, New York and Worcester, MA. What looked like risky locations to others looked like profitable opportunities to Alexandria due to their superior trend research.
Historically pharma companies built their headquarters, and labs, in suburban locations where development was easy, and labs were welcome. Alexandria realized the new trend for emerging companies was to be near universities in urban environments, and although land was costly — and development more difficult — this was the right place to leverage the trend.
Today Alexandria is the bona fide market leader in labs and tech facilities in the USA. By seeing the trend early they bought land which is now so expensive it is practically untouchable – even for $1 billion. Their development pipeline includes Mission Bay, Kendall Square, the Manhattan borough of New York City and RTP (Research Triangle Park.) Today companies want to be where the lab is — and frequently the lab space is now owned, or being developed, by Alexandria.
This didn’t happen by accident. Not at the beginning nor as Alexandria plans its future growth. The company maintains a team of 13 researchers studying market trends in technology, and under-served real estate needs. They constantly track employers of tech/research people, competitors, historical and emerging customers — and identify prospective tech tenants who will need specialized real estate. A few of the leading trends Alexandria follows include:
- Urbanization — The siloed campuses set in bucolic suburbs is the past
- Innovation externalization — Over 50% of innovation in big pharma is now outsourced. And universities are spinning out innovations faster than ever into development centers for testing and commercialization
- Nutrition and disease management — These are emerging markets ripe with new products making their way to commercialization, and needing space to grow
Alexandria’s historical and ongoing successes relied first and foremost on using trends to understand underserved markets where needs will soon be the greatest. This is an important lesson for all businesses. No matter what you do, what you sell, or your industry you can generate higher returns, outperform your peers, and outperform the market rewarding investors by identifying trends and investing in them.
Thanks to Joel Marcus for providing an interview to explain the history and current practices at Alexandria.
People love to watch tech stocks, because there is so much volatility. Just today (April 27, 2017) Alphabet beat expectations and its shares rose $34 (about 4%) after hours. GOOG is up 15.5% in 2017, and 31% for the year. But not all tech stocks do this well. Twitter, for example, had a nice increase of late — but TWTR is down 33% since peaking in early October, and it is down 69% from 10/2014 highs.
So how is an investor to know which tech stocks to own, and which to eschew?
They key, of course, is to watch trends. And to recognize who absolutely dominates those trends. When it comes to the rapidly growing world of social media, it is increasingly clear there is only one Goliath — and that is Facebook.
Felix Richter, Statista
Snapchat created a lot of interest when it hit the scene. A darling of the most youthful set, it was growing very fast and had exceeded 100 million users by January 2016. By January 2017 Snapchat added another 60 million users — growing 60%. But since going public the stock has dropped about 10%. And according to Marketwatch only 12 analysts rank it a “buy” while 23 rank it a “hold,” “underweight” or “sell.”
Should you buy Snapchat? After all, Facebook dropped after its IPO
As the chart from Statista shows, in just eight months Instagram Stories has blown way past the user base of Snapchat. In April 2012 Facebook paid $1 billion for Instagram, then a popular photo-sharing app, which had no revenues. The idea was to leverage Facebook’s installed base to grow the app. Since September, 2013 Instagram has been adding 50 million users per quarter. Instagram now has 600 million active users and became one of the five most popular mobile apps in the world.
Felix Richter, Statista, https://www.statista.com/chart/5055/top-10-apps-in-the-world/
The Facebook App Ecosystem Totally Dominates Mobile. Chart reproduced courtesy of Felix Richter at Statista
Looking at Facebook, one has to marvel at how the company has kept users in its ecosystem. As the Statista chart shows, since 2016 Facebook has had four of the top five mobile app downloads. Now that Instagram Stories has blown past Snapchat, Facebook holds all four top positions.
Does anyone remember when Facebook purchased Beluga in 2011 for about $20 million? That is now Messenger, and it opened the door for sending pictures and video. Do you remember the $19 billion acquisition of WhatsApp — which had only $10 million in revenues? Both have added multiple capabilities, and now Messenger has 1 billion active users, and WhatsApp has 1.2 billion users.
In fiscal 2012 Facebook hit $1 billion in quarterly revenue, and ended the year with just over $4 billion in annual revenues. Q4 2016 exceeded $8.8 billion, and for the year $27.6 billion.
It is for good reason that almost twice as many analysts are skeptical of Snapchat’s future value as those who think it will go up.
Snapchat is competing with Facebook, a company that has shown time and again it can watch the trends and put in place products that initially meet, but then eventually exceed customer expectations. One might like to think Snapchat is a good David, putting up a good fight. But this time, investors are likely to be much better off betting on Goliath. Facebook still has a lot of opportunity to grow.
When I was young, IBM dominated computing. In the tech world, when comparing platforms, everyone said, “Nobody ever got fired for buying IBM.” IBM was a standout role model for sales success, product leadership and investor returns.
Now, not so much. IBM’s stock fell almost 5% on Wednesday after the company reported “lackluster” results. For the week IBM lost about $20 per share – almost 12%. Quarterly revenue last quarter fell 3%, making 20 consecutive quarters of declining revenue for the once-dominant behemoth and Dow Jones Industrial Average (DJIA) component.
CEO of IBM Ginni Rometty (Photo by Neilson Barnard/Getty Images for New York Times)
The stock is still up from January 2016 lows of $125, and you might think this pullback is a buying opportunity. But you would be wrong. For long-term investors the stock has fallen from about $194 when CEO Ginni Rometty took control to the recent $160 — a 17.5% decline over five years. And that is after spending $9 billion on payouts (mostly share buybacks) to prop up the stock!
But because of its long-term “growth stall” the odds are almost a certainty things will continue to worsen for IBM.
(c) Adam Hartung and Spark Partners
Growth Stalls are Deadly Accurate Predictors of Future Value Declines
When a company has two consecutive declining quarters of revenue or earnings, or two consecutive quarters of revenue or earnings lower than the previous year, that company is in a “growth stall.” After stalling, 93% of companies will struggle to consistently grow a mere 2%. Seventy percent will lose more than half their market cap.
I made this same call, to not own IBM, in May 2014
. Then IBM had registered a stall on both the quarter-to-quarter metric, and on the year-over-year quarterly metric. IBM was clearly in a “growth stall” and showed no signs of turning around its fortunes. Now IBM has failed to grow quarterly revenue for five years!
Supported by the company PR and investor relations departments, optimists will claim there is reason to think things will improve. For example, in September 2015 IBM executive John Kelly predicted that Watson would be the next “huge engine” for growth. Today the Cognitive Computing segment that is Watson is about the same size it was then. In fact none of the five IBM segments are showing strong growth.
The reason a “growth stall” is such an accurate predictor of future bad results is its ability, in a very simple way, to describe when a company falls out of step with its customers/marketplace. The market went one way — in this case to mobile apps, mobile devices and cloud computing — while the company remained in outdated businesses and launched competitive offerings too late to catch the early market makers. At IBM, Cognitive has not become a big new market, while the historical Business Services and Systems segments keep shrinking, and Cloud Services is simply out-gunned by competitors like Amazon.
Rometty should be replaced by someone from outside IBM.
Meanwhile, the CEO keeps her job and even achieves pay raises! In 2016 IBM’s stock had dropped 36% since Rometty took the CEO position, yet the board of directors payed out the max bonus, leading the LA Times to headline “IBM’s CEO Writes a New Chapter on How To Turn Failure Into Wealth.” Last year the company share price bounced of its lows, but still far below what it was when she took the job, and in 2017 the Board increased her bonus from 2016! And the CEO will be granted a long-term pay incentive of $13.3 million in June (to be paid in 2020).
Like Immelt at GE, Rometty should be fired. If there were an updated list of the “5 Worst CEO’s Who Should Have Already Been Fired,” CEO Rometty surely deserves to be on it. And a new leader needs to implement an entirely new strategy if IBM is ever to regain its lost glory.
IBM’s stock may bounce around quite a bit. It’s shareholder base is very large. And really big investors, like pension funds and mutual funds, are very slow to dump their positions. But, eventually, everyone realizes that a shrinking company is not a value creation company, and they keep selling shares into any sign of strength. Big investors eventually recognize when a Board is unwilling to actually help lead a company, and unwilling to face down a bad CEO and replace her with someone more competently able to turn around a perennial terrible performer. So they start selling before the bottom falls out — like Sears and AT&T after they were removed from the DJIA.
There’s a lot more downside potential for IBM’s valuation.
In IBM’s case, the shares are at about $195 when the first data indicating a growth stall were evident (Q3 2012). They then peaked at $213 in March 2013. And it has been an ugly ride since. he “bounce” in 2016 from $125 to $180 was actually the best selling opportunity since September 2014 (just after I made the call to get out). At $160, IBM is down about 18% since the growth stall started (largely due to share buybacks) and revenues have kept dropping. According to “growth stall” analysis there is a 69% probability IBM’s shares will fall to $85 per share — or less — before the company fails, or starts a true, long-term recovery under new leadership.
(Photo: CEO of Amazon.com, Inc. Jeff Bezos, TOMMASO BODDI/AFP/Getty Images)
Amazon.com is now worth about the same as Berkshire Hathaway. Amazon has had an amazing run-up in value. The stock is up 17% year to date, and 46% over the last 12 months. By comparison, Berkshire has risen 3.1% this year and Microsoft has risen 5.6% —while the S&P 500 is up 5.8%. Due to this greater value increase, Jeff Bezos has become the second richest man in the world, jumping past Warren Buffett while Bill Gates remains No. 1.
Obviously, it wouldn’t take much of a slip in Amazon, or a jump in Berkshire, to reverse the positions of the companies and their CEOs. But it is important to recognize what is happening when a barely profitable company that sells general merchandise, technology products (Kindles, Fires and Echos) and technology services (AWS) eclipses one of the most revered financial minds and successful investment managers of all time.
Warren Buffett (Photo by Paul Morigi/Getty Images for Fortune/Time Inc)
Berkshire Hathaway was a financial pioneer for the Industrial Era. Warren Buffett bought a down-and-out textile company and created enormous value by turning it into a financial powerhouse. At the time America, and the world, was still in the Industrial Revolution. Making things – manufacturing – was the biggest industry of all. Buffett and his colleagues recognized that capital for these companies was deployed very inefficiently. Often too much capital was invested in poor ways, while insufficient capital was invested in good opportunities. If Berkshire could build a capital base it could deploy that capital into high-return opportunities, and make above-average rates of return.
When Buffett started his magical machine he realized that capital was often in short supply. Companies had to ration capital, unable to build the means of production they desired. Banks were unwilling to lend when they perceived any risk, even when the risk was not that great. Simultaneously investment banks were highly inefficient. The industry was unwilling to support companies prior to going public, often uninterested in taking companies public, and poor at allocating additional capital to the highest return opportunities. By the time you were big enough to use an investment bank you really didn’t need them to raise capital – they just organized the transactions.
This inefficiency in capital allocation meant that an investor with capital could create tremendous gains by deploying it in high return opportunities that often had minimal risk – or at least risk that could be offset with other investments.
Berkshire Hathaway was a big winner at mastering finance during the industrial era. By putting money in the right place, at the right time, tremendous gains could be made. Berkshire didn’t have to be a manufacturer, it could make a higher rate of return by understanding how to deploy capital to industrial companies in a marketplace where capital was rationed. In other words, give people money when they need it and Berkshire could generate outsized returns.
It was a great strategy for supporting companies in the Industrial Age. And a great way to make money when capital was hard to come by.
But the world has changed. Two important things happened First, capital became a lot easier to acquire. Deregulation and a vast expansion of financial services led to a greater willingness to lend by banks, larger secondary markets for bank-originated products that carried risk, the creation of venture capital and private equity firms willing to invest in riskier opportunities, and a dramatic growth in investment banking globally making it far easier to go public and raise equity. Capital became vastly more available, and the cost of capital dropped dramatically.
This made finding opportunities for outsized returns just based on investing considerably more difficult. And thus every year it has become harder for Berkshire Hathaway to find investment opportunities that exceed market rates of return. Berkshire isn’t doing poorly, but it now competes in a world of many competitors who have driven down returns for everyone. Thus, Berkshire’s returns increasingly move toward the market norm.
The Industrial Era is dead — usher in the Information Era. Second, we are no longer in the Industrial Age. Sometime in the 1990s (economic historians will pin it to a specific date eventually) the world transitioned into the Information Age. In the Information Age assets are no longer worth as much as they previously were. Instead, information has become much more valuable. What a business knows about customers, markets and supply chains is worth more than the buildings, machines and trucks that actually make up the physical economy. The value from having information has become much higher than the value of things — or of providing capital to purchase things.
In the Information Era, few companies have mastered the art of information management better than Amazon.com. Amazon doesn’t succeed because it has great retail stores, or great product inventory or even great computers. Amazon’s success is based on knowing things about markets and its customers. Amazon has piles and piles of data, and Amazon monetizes that information into sales.
By studying customer habits, every time they buy something, Amazon has been able to make the company more valuable to customers. Often Amazon is able to tell a customer what they need before they realize they need it. And Amazon is able to predict the flow of new product introductions, and predict sales for manufacturers with great accuracy. Amazon is able to understand what media customers want, and when they’ll want it. Amazon is able to predict a business’ “cloud needs” before that business knows – and predict the customer’s likely future services needs long before the customer knows.
In the Information Age, Amazon is one of the very, very best information companies out there. It knows how to obtain information, analyze those mounds of “big data” to determine and predict needs, then connect customers with things they want to buy. Being great at information means that Amazon, even with its relatively poor current profits, is positioned to capitalize on its intellectual property for years to come. Not without competition. But with a tremendous competitive lead.
So, how is your portfolio allocated? Are you invested in assets, or information? Accumulating assets is a very hard way to make high rates of return. But creating sales, and profits, out of information is far easier today. The relative change in the value of Amazon and Berkshire is telling investors that it is now smarter to be long information rich companies than asset rich companies.
If you’re long GE, GM, 3M and Walmart how well will you do in an economy where information is more valuable than assets? If you don’t own data rich, analytically intensive companies like Amazon, Facebook, Alphabet/Google and Netflix how would you expect to make above-average rates of return?
And where is your business investing? Are you still putting most of your attention on how you allocate capital, in a world where capital is abundant and cheap? Are you focusing your attention on getting the most out of what you know about markets, customers and suppliers, or just making and selling more stuff? Do you invest in projects to give you insights competitors don’t have, or in making more of the products you have — or launching product version X?
And are you being smart about how you manage your most important information tool — your talented employees? Information is worthless without insight. It is critical companies today do all they can to help employees develop insights, and then rapidly deploy those insights to grow sales. If you spend a few hours pouring over expenses to find dimes, consider letting that activity go in order to spend hours brainstorming how to find new markets and new product opportunities that can generate a lot more revenue dollars.
(Photo: General Electric CEO Jeffrey Immelt, ERIC PIERMONT/AFP/Getty Images)
General Electric stock had a small pop recently when investors thought CEO Jeffrey Immelt might be pushed out. Obviously more investors hope the CEO leaves than stays. And it appears clear that activist investor Nelson Peltz of Trian Partners thinks it is time for a change in CEO atop the longest running member of the Dow Jones Industrial Average (DJIA.)
You can’t blame investors, however. Since he took over the top job at General Electric in 2001 (16 years ago) GE’s stock value has dropped 38%. Meanwhile, the DJIA has almost doubled. Over that time, GE has been the greatest drag on the DJIA, otherwise the index would be valued even higher! That is terrible performance — especially as CEO of one of America’s largest companies.
But, after 16 years of Immelt’s leadership, there’s a lot more wrong than just the CEO at General Electric these days. As the JPMorgan Chase analyst Stephen Tusa revealed in his analysis, these days GE is actually overvalued, “cash is weak, margins/share of customer wallet are already at entitlement, the sum of the parts valuation points to a low 20s stock price.” He goes on to share his pessimism in GE’s ability to sell additional businesses, or create cost lowering synergies or tax strategies.
Former Chairman and CEO of General Electric Jack Welch. (AP Photo/Richard Drew)
What went so wrong under Immelt? Go back to 1981. GE installed Jack Welch as its new CEO. Over the next 20 years there wasn’t a business Neutron Jack wouldn’t buy, sell or trade. CEO Welch understood the importance of growth. He bought business after business, in markets far removed from traditional manufacturing, building large positions in media and financial services. He expanded globally, into all developing markets. After businesses were acquired the pressure was relentless to keep growing. All had to be no. 1 or no. 2 in their markets or risk being sold off. It was growth, growth and more growth.
Welch’s focus on growth led to a bigger, more successful GE. Adjusted for splits, GE stock rose from $1.30 per share to $46.75 per share during the 20 year Welch leadership. That is an improvement of 35 times – or 3,500%. And it wasn’t just due to a great overall stock market. Yes, the DJIA grew from 973 to 10,887 — or about 10.1 times. But GE outperformed the DJIA by 3.5 times (350%). Not everything went right in the Welch era, but growth hid all sins — and investors did very, very, very well.
Under Welch, GE was in the rapids of growth. Welch understood that good operating performance was not enough. GE had to grow. Investors needed to see a path to higher revenues in order to believe in long term value creation. Immediate profits were necessary but insufficient to create value, because they could be dissipated quickly by new competitors. So Welch kept the headquarters team busy evaluating opportunities, including making some 600 acquisitions. They invested in things that would grow, whether part of historical GE, or not.
Jeff Immelt as CEO took a decidedly different approach to leadership. During his 16 year leadership GE has become a significantly smaller company. He sold off the plastics, appliances and media businesses — once good growth providers — in the name of “refocusing the company.” Plans currently exist to sell off the electrical distribution/grid business (Industrial Solutions) and water businesses, eliminating another $5 billion in annual revenue. He has dismantled the entire financial services and real estate businesses that created tremendous GE value, because he could not figure out how to operate in a more regulated environment. And cost cutting continues. In the GE Transportation business, which is supposed to remain, plans have been announced to double down on cost cutting, eliminating another 2,900 jobs.
Under Immelt GE has focused on profits. Strategy turned from looking outside, for new growth markets and opportunities, to looking inside for ways to optimize the company via business sales, asset sales, layoffs and other cost cutting. Optimizing the business against some sense of an historical “core” caused nearsighted — and shortsighted — quarterly actions, financial gyrations and transactions rather than building a sustainable, growing revenue stream. Under Immelt sales did not just stagnate, sales actually declined while leadership pursued higher margins.
By focusing on the “core” GE business (as defined by Immelt) and pursuing short term profit maximization, leadership significantly damaged GE. Nobody would have ever imagined an activist investor taking a position in Welch’s GE in an effort to restructure the company. Its sales growth was so good, its prospects so bright, that its P/E (price to earnings) multiple kept it out of activist range.
But now the vultures see the opportunity to do an even bigger, better job of whacking up GE — of tearing it into small bits while killing off all R&D and innovation — like they did at DuPont. Over 16 years Immelt has weakened GE’s business — what was the most omnipresent industrial company in America, if not the world – to the point that it can be attacked by outsiders ready to chop it up and sell it off in pieces to make a quick buck.
Thomas Edison, one of the world’s great inventors, innovators and founder of GE, would be appalled. That GE needs now, more than ever, is a leader who understands you cannot save your way to prosperity, you have to invest in growth to create future value and increase your equity valuation.
In May, 2012 (five years ago) I warned investors that Immelt was the wrong CEO. I listed him as the fourth worst CEO of a publicly traded company in America. While he steered GE out of trouble during the financial crisis, he also simply steered the company in circles as it used up its resources. Then was the time to change CEOs, and put in place someone with the fortitude to develop a growth strategy that would leverage the resources, and brand, of GE. But, instead, Immelt remained in place, and GE became a lot smaller, and weaker.
At this point, it is probably too late to save GE. By losing sight of the need to grow, and instead focusing on optimizing the old business while selling assets to raise cash for reorganizations, Immelt has destroyed what was once a great innovation engine. Now that the activists have GE in their sites it is unlikely they will let it ever return to the company it once was – creating whole new markets by developing new technologies that people never before imagined. The future looks a lot more like figuring out how to maximize the value of each piece of meat as it’s carved off the GE carcass.
(Photo by Scott Olson/Getty Images)
Traditional retailers just keep providing more bad news. Payless Shoes said it plans to file bankruptcy next week, closing 500 of its 4,000 stores. Most likely it will follow the path of Radio Shack, which hasn’t made a profit since 2011. Radio Shack filed bankruptcy and shut a gob of stores as part of its “turnaround plan.” Then in February Radio Shack filed its second bankruptcy — most likely killing the chain entirely this time.
Sears Holdings finally admitted it probably can’t survive as a going concern this week. Sears has lost over $10 billion since 2010 — when it last showed a profit — and owes over $4 billion to its creditors. Retail stocks cratered Monday as the list of retailers closing stores accelerated: Sears, KMart, Macy’s, Radio Shack, JCPenney, American Apparel, Abercrombie & Fitch, The Limited, CVS, GNC, Office Depot, HHGregg, The Children’s Place and Crocs are just some of the household names that are slowly (or not so slowly) dying.
None of this should be surprising. By the time CEO Ed Lampert merged KMart with Sears the trend to e-commerce was already pronounced. Anyone could build an excel spreadsheet that would demonstrate as online retail grew, brick-and-mortar retail would decline. In the low margin world of retail, profits would evaporate. It would be a blood bath. Any retailer with any weakness simply would not survive this market shift — and that clearly included outdated store concepts like Sears, KMart and Radio Shack which long ago were outflanked by on-line shopping and trendier storefronts.
Yet, not everyone is ready to give up on some retailers. Walmart, for example, still trades at $70 per share, which is higher than it traded in 2015 and about where it traded back in 2012. Some investors still think that there are brick-and-mortar outfits that are either immune to the trends, or will survive the shake-out and have higher profits in the future.
And that is why we have to be very careful about business myths. There are a lot of people that believe as markets shrink the ultimate consolidation will leave one, or a few, competitors who will be very profitable. Capacity will go away, and profits will return. In the end, they believe if you are the last buggy whip maker you will be profitable — so investors just need to pick who will be the survivor and wait it out. And, if you believe this, then you have justified owning Walmart.
Only, markets don’t work that way. As industries consolidate they end up with competitors who either lose money or just barely eke out a small profit. Think about the auto industry, airlines or land-line telecom companies.
Two factors exist which effectively forces all the profits out of these businesses and therefore make it impossible for investors to make money long-term.
First, competitive capacity always remains just a bit too much for the market need. Management, and often investors, simply don’t want to give up in the face of industry consolidation. They keep hoping to reach a rainbow that will save them. So capacity lingers and lingers — always pushing prices down even as costs increase. Even after someone fails, and that capacity theoretically goes away, someone jumps in with great hopes for the future and boosts capacity again. Therefore, excess capacity overhangs the marketplace forcing prices down to break-even, or below, and never really goes away.
Given the amount of retail real estate out there and the bargains being offered to anyone who wants to open, or expand, stores this problem will persist for decades in retail.
Second, demand in most markets keeps declining. Hopefuls project that demand will “stabilize,” thus balancing the capacity and allowing for price increases. Because demand changes aren’t linear, there are often plateaus that make it appear as if demand won’t go down more. But then something changes — an innovation, regulatory change, taste change — and demand takes another hit. And all the hope goes away as profits drop, again.
It is not a successful strategy to try being the “last man standing” in any declining market. No competitor is immune to these forces when markets shift. No matter how big, when trends shift and new forms of competition start growing every old-line company will be negatively affected. Whether fast, or slow, the value of these companies will continue declining until they eventually become worthless.
Nor is it successful long-term to try and segment the business into small groupings which management thinks can be protected. When Xerox brought to market photocopying, small offset press manufacturers (ABDick and Multigraphics ) said not to worry. Xeroxing might be OK in some office installations, but there were customer segments that would forever use lithography. Even as demand shrunk, well into the 1990s, they said that big corporations, industrial users, government entities, schools and other segments would forever need the benefits of lithography, so investors were safe. Today the small offset press market is a tiny fraction of its size in the 1960s. ABDick and Multigraphics both went through rounds of bankruptcies before disappearing. Xerography, its child desktop publishing, and its grandchild electronic screens, killed offset for almost all applications.
So don’t be lured into false hopes by retailers who claim their segment is “protected.” Short-term things might not look bad. But the market has already shifted to e-commerce and this is just round one of change. More and more innovations are coming that will make the need for traditional stores increasingly unnecessary.
Many readers have expressed their disappointment in my chronic warnings about Walmart. But those warnings are no different than my warnings about Sears Holdings. It’s just that the timing may be different. Both companies have been over-investing in assets (brick-and-mortar stores) that are declining in value as they have attempted to defend and extend their old business model. Both radically under-invested in new markets which were cannibalizing their old business. And, in the end, both will end up with the same results.
And this is true for all retailers that depend on traditional brick-and-mortar sales for their revenues and profits — it’s only a matter of when things will go badly, not if. So traditional retail is nowhere that any investor wants to be.
The vast majority of individual investors have no idea how to pick stocks. So they often let someone else invest for them, and pay a hefty fee of anywhere from 1% to 5% of their assets annually. Or they buy some sort of fund or portfolio index, where they pay the fund manager usually more than 1% of assets for managing the fund. In the worst case, they pay the financial advisor their fee, and then the advisor buys a fund for the investor – which has that investor paying anywhere from 2% to 8% or even 10% of assets annually for investment advice.
Yet, we know that few asset managers can beat “the market,” whether measured by the DJIA (Dow Jones Industrial Average) or the S&P 500. A study in Europe showed no active manager beat their benchmark over 10 years, and in the U.S. 80% to 90% of fund managers failed to do as well as their benchmarks. And there are studies showing that even if a manager beats their index, after accounting for management fees and costs the investors almost never beat the market.
Any individual could buy the market index by simply opening an on-line account at any discount brokerage, for a very small cost, and buying the exchange traded fund (ETF) for the Dow (DIA – often called “Diamonds”) or the S&P (SPDR – often called “Spiders”). Thus, individual investors can do as well as the “market” at very, very low cost. Most academics will tell investors to not try and beat the market, because the market is wildly inefficient and investors are always without full knowledge of the company, and thus buy these indices.
But most investors are lured by the notion of “beating the market” so they pay the high fees in order to – hopefully – have someone do a better job of investing. And they end up disappointed.
Investors can “beat the market,” but it requires a different approach to investing than fund managers use. And it is far more suited to individuals, with long-term horizons – and it avoids paying those outrageous financial services fees. To be a long-term high-return investor individuals simply need to invest in trends.
247wallst.com published an article stating the editors had seen a report published by Jefferies, sent to them by Bloomberg, which claimed that 20% of all the gains in the total stock market since 1924 (some 93 years) were created by a mere 14 stocks. This sort of blows up all academic theories about investing in portfolios, as it drives home that most market returns are driven by a small collection of companies. Individuals would be better off if they invested in just a few stocks, rather than all stocks. But this means you have to know which stocks to own.
You would think this might be hard, until you look at the list of 14. There is a striking pattern. All were simply the biggest, most powerful companies leading an important, large trend. So if you identified the trend, and invested in the largest company creating that trend, you would do really well. And because these are large companies, investors aren’t carrying the risk of small companies that could be competitively destroyed by larger players. Interestingly, identifying these trends and the large players really isn’t that hard. Nor is it hard to recognize when the trend is ending, and it is time to sell.
We can understand this by looking at the list of 14 not by how much market gain they created, but rather historically when the majority of those gains occurred.
People have enjoyed smoking tobacco since at least the 1500s. Long before anyone knew about the chemical affects and shortened lifespan people simply enjoyed the practice of smoking and the impact nicotine had on them. As tobacco spread from France to England, eventually it moved to the U.S. and was the first ever cash crop – grown in America for sale in Europe. For literally hundreds of years the trend toward tobacco consumption grew. So, it is easy to understand why investing in Phillip Morris, which was renamed Altria, was a good move. As long as people kept buying more cigarettes investing in the largest cigarette company was a good way to increase your returns.
For hundreds of years people used whale oil and similar animal products for candles and lanterns. Wood and coal were used for cooking. But then in 1859 oil was successfully found, and it changed the world. Oil was far cheaper to produce than animal or vegetable oils and burned more consistently at a higher temperature than those products, wood or coal. And that unleashed a trend toward hydrocarbon production leading to the birth of countless new products. It would not have been hard to see that this trend was going to be very valuable. Thus two other names on the list pop up, Exxon and Chevron. These companies are successors of the original Standard Oil founded by John Rockefeller – which created tremendous returns for investors for many years as oil consumption, and production, grew.
Hydrocarbons were a tremendous contributor to the industrial revolution, allowing manufacturers to use engines in new products, and to improve their manufacturing. One of the earliest, and soon biggest, manufacturers was General Electric, another big value producer on the list of 14. And one of the biggest industrial revolution gains was the automobile, where General Motors became by far the largest producer. Investors who put money into the industrial revolution and the trend toward making things – especially cars – came out very well by buying shares in these two companies.
As the industrial revolution grew the middle class emerged, enjoying a vast improvement in quality of life. This led to the trend of consumerism, as it was possible to make things much cheaper and distribute them wider. Three of the biggest companies that promoted this consumer trend were Johnson & Johnson, Proctor & Gamble and Coca-Cola. All were in different product markets, but all were very big leaders in the growth of consumer products for a 1900s world (especially post-WWII) where people had more money – and the desire to buy things. And all three did very well for their investors.
Soon a new trend emerged with the capability of electronics. First came the advent of instant, modern communications as the telephone emerged. Regardless the cost, there was high value in being able to communicate with someone “now” even if they were in a distant location. Investors in Alexander Bell’s AT&T did quite well as phones made their way across America and around the world.
Soon thereafter mechanical adding machines were greatly improved by using electronics – initially relays – to make tabulations and computations. IBM was an early developer of these machines for commercial use, and very quickly came to dominate the market for computers. It was not long before every company needed a computer, or at least access to use one, in order to compete. Investors in IBM were well rewarded for spotting this trend.
As the market for consumer goods exploded Sam Walton recognized the inefficiency of retail product distribution. He discovered that by owning more stores he could negotiate better with consumer goods manufacturers, purchase products more cheaply and sell them more cheaply. He created the trend toward mass retailing driven by efficiency, and he rapidly demonstrated the ability to drive competitors completely out of many retail markets. Investors who identified this trend toward low-cost retailing of a wide product array made considerable gains by purchasing Wal-Mart shares.
As computers became smaller the market expanded, leading to the development of ever smaller computers. Microsoft created software allowing multiple manufacturers to build machines with interoperability, allowing it to take a dominant position in the trend to computers so small every single person could have one – and indeed eventually felt they could not live without one. Microsoft investors made huge gains as the company practically monopolized this trend and created the personal compute marketplace.
It was Apple that first recognized the trend toward mobility being created by ever faster connection speeds. Mobility would allow for radical changes in how many product markets behaved, and investors who saw this mobility trend were amply rewarded for investing in Apple – the company that became synonymous with internet-enabled products.
And as computing mobility improved it created a trend toward buying at home rather than going to a store. Mail order had almost entirely disappeared, due to lack of timely product fulfillment. But with the internet as the interface, coupled with modern, highly efficient transportation services, Amazon was able to give a rebirth to shopping from home and the e-commerce trend exploded. Investors that recognized Amazon’s vastly lower cost retail model, coupled with the infinite prospects for product variety, have been rewarded for investing in the large on-line retailer.
These 14 companies created 20% of all stock market gains across nearly a century. And each was the dominant competitor in a major trend. Several are no longer on the trend, and even a couple have filed bankruptcy (like AT&T and GM), thus it is easy to recognize why some have done far less well the last decade. The world changed and their business model which once produced excellent returns no longer does. But savvy investors should recognize when a trend has run its course, and drop that company in favor of investing in the leader of a major, new trend.
All investors should be long-term investors. Trying to be a market timer, and a trader, is a fool’s errand. To make high investment returns requires taking a long-term (multi-year) view – not monthly or quarterly. Therefore it is important that when investing in trends they be big trends. Trends that will have a large impact on every business – every person. Trends that can generate tremendous returns for many years.
Not everyone can be a stock picker. Therefore, most investors should probably have a goodly chunk of their money in an ETF. That can be done easily enough as described above. But, if you want to increase your returns to beat the market the key is to invest in companies that are large, and the leaders in a major trend.
What are the big trends today? There is no doubt “social” is a huge trend. How every business and person interacts is changing as the use of social tools increases. This is a global phenomenon, and it is a trend with many years left to extend its impact. Investing in the market leader – Facebook – shows good likelihood of obtaining the kind of returns created by the 14 companies discussed above.
What other trends can you identify that have years yet to go? If you can spot them, and invest in a dominant, large leader then you just may outperform nearly every active fund manager trying to get you to pay their fees.