Thursday, August 12, 2010

The Risks To Earnings

Investments in individual companies can often be divided into two different types: asset plays and earnings plays. In an asset play, the investor believes the current share price is below what the company's assets are worth, and so he expects to benefit from those assets in some way (example here). In an earnings play, the investor believes future earnings are strong as compared to the stock's current price (example here). In each case, the risks to the investor are different; as such, the identification of the type of investment being made is important so that the investor can focus on the right risks in making an investment decision.

Consider ADDvantage Technologies (AEY), a company previously discussed on this site as a potential value investment. Eight months ago, the company was trading at a discount to its net current assets, and at a rather large discount to its book value. As such, the fact that the company sources 35% of its purchases from one company (Cisco Systems) was not a huge risk. After all, if Cisco severed its supply relationship with ADDvantage, the company could still turn its inventory into cash and would still trade at a discount to its assets, even if it incurred some losses as a result. We've seen this come to fruition at Nu Horizons (NUHC), where the stock fell following the release that Xilinx would no longer distribute through Nu Horizons; but the Xilinx inventory has been turned into cash, and the company remains an attractive asset play.

But today, ADDvantage's price has appreciated such that it is no longer an asset play. Nevertheless, the company remains an earnings play. But the risk profile has changed as a result. As an earnings play, the company's reliance on Cisco as a major supplier (and the impending negotiations that are on-going as a result of the contract's nearing end of term) becomes a major risk, because a major source of earnings for the company is its ability to purchase and sell certain Cisco products; without that ability, the earnings will have to be replaced by other products, or they will fall.

Asset plays and earnings plays have different risk characteristics. For example, in an asset play, risks to the quality/liquidity of the company's assets are much more important than they are in an earnings play. On the other hand, issues such as supplier risk (as is the case in the above example) are much more important when a purchase is made for a company's earnings. For the investor, it is important to identify the type of investment play that is being made (i.e. Is the investor after the company's future earnings, or its current asset position?) so that the right types of risk can be identified and brought into focus.

Disclosure: Author has a long position in shares of AEY


Anonymous said...

fantastic way to think of risks depending on the type of investment play..

Unknown said...

hey saj, when warren buffet lists his returns for the year, is he listing just realized gains? For long term investors I wonder how they produce yearly realized returns when our ideal situation is to hold onto a stock that grows 10% a year for 10 years.

Rather than short term hedge fund managers that are constantly selling to show a high return.

Saj Karsan said...

Hi AK,

The accounting rules vary depending on the level of influence/ownership Berkshire has over the investment. The returns of a company Berkshire owns most of would be fully consolidated, and therefore the only returns would come from the company's actual net income. On the other hand, for the returns of a company Berkshire barely owns (e.g. if it owns 1% of a public company), it would be the unrealized (plus realized, if any) stock returns.

So to answer your question more directly, I would say Berkshire's book value (and changes to it) do reflect unrealized gains to a large extent.