Tuesday, June 15, 2010

Offending The Defensive

Companies will often take credit when revenue growth outperforms economic growth, using sentences beginning with "Despite the current situation, we...". But these same companies will be quick to blame the economy in the face of lower than expected results (e.g. "The economic crisis caused..."). Therefore, the investor needs to be able to determine whether management is indeed outperforming.

Despite the general economic malaise currently gripping the global economy, it is still possible to find companies experiencing record sales and profits. But some companies may be beneficiaries of circumstance. These companies could be in industries with positive long-term trends (e.g. health, education), they could be in industries that aren't much affected by recessions (e.g. producers of consumer staples), or they could be operating in niche segments that for whatever reason are experiencing temporary bouts of strong demand or little in the way of competition. To avoid overpaying for such a company, it's important for investors to be able to identify whether external factors (which may be temporary) are benefitting a company.

If a company is earning record profits in a recession, but is simply in a cyclical industry, it is likely attracting competition. When a company generates high returns on capital, it attracts competition looking to replicate those same returns. For most companies, this results in returns returning to normal levels, as the competition drives down margins. For some industries, this process can take years (e.g. high oil prices encourage drilling and innovation resulting in higher oil supplies, but this takes a long time), while in others it can be a matter of weeks.

Consider Kewaunee Scientific (KEQU), maker of laboratory furniture. A combination of favourable factors for demand along with low competition resulted in strong revenues for this company in 2009. But it's important to have kept those numbers in perspective. Assuming that those revenue and profit levels would continue for the foreseeable future would have resulted in an investor's overvaluation of its stock. In other words, it was easy to have gotten sucked into believing that those numbers would only improve, considering that we were in a recession.

Indeed, management's comments at that time suggested the company was resilient in the face of recession:

"Our programs and strategies over the past few years to make Kewaunee a stronger and more competitive company were put to the test. Despite [economic] and other challenges, year-over-year increases in sales and net earnings were achieved for each quarter of the year..."

As we've often discussed, however, investors must look at several years worth of data to determine if a company's current operating profits are indeed sustainable. If a company does not have a competitive advantage, high margins will simply encourage competition that drives margins back down to normal levels. A look at KEQU's revenue and margins over the last business cycle shows that last year it was operating as well as it ever has:

Not long ago, however, the company suffered from low demand resulting in margin erosion. In 2005, revenues and earnings dropped sharply. Did the company blame itself, in what was otherwise a strong economic period? Not likely, as it issued the following commentary:

"We accomplished much in realizing cost reductions and improving our products, but were not able to overcome the unfavorable marketplace and declining sales...Uncertainties surrounding the November presidential election, significant increases in construction costs, and fewer state funds available for projects, all combined to reduce the number of laboratory projects..."

To determine whether current revenues and margins are sustainable, investors must consider the underlying business. Does the company have a competitive advantage which should allow it to hold onto its record profits, or is demand cyclical and/or will competition reduce profitability to more normal levels? Rather than accept the biased explanation of managements, investors must use their own judgement, and not only rely on current earnings (which may be abnormally high) in valuing a company.

Indeed, this type of analysis suggested the company's 2009 margins and revenue growth were not sustainable, and that turned out to be the case. In the latest quarter, the company saw sharply lower revenue and margins, and of course blamed "a soft market for small laboratory furniture projects, and unusually bad weather". This management behaviour of "take credit when things go well, blame others when things go badly" is nothing new and is not limited to this one company; rather, it is common business practice. As such, as investors it's our job to think beyond what we hear from the managers.

Disclosure: None


Andrew said...


What are your thoughts on ACU's ability to maintain a ROIC greater than its cost of capital given that most of its products are a relatively commoditized industry?


Ankit Gupta said...

You made a lot of great points here and the messages management sends out when outperforming the market and when they underperform tells us a lot about their level of honesty and transparency.

When we invest in a company, what we're really buying is like a foreign currency. It's a piece of paper with the CEO and CFO's portrait on the front and company logo on the back.

You are counting on them to not dilute the currency (inflation) and you want it to be redeemable for future goods and services (hold value or appreciate).

I'm not going to hand $20 to someone who won't pay me back and investing is no different. I won't hand the CEO and CFO to run a business with me $20 unless I absolutely trust them.

I don't care _at all_ about what the industry norm is - I want executives who are honest and transparent - show consistency with it too. Don't be honest and transparent only when things go well, but also when things go bad.

Taking credit when things go well and passing the blame when things don't go so well is not a good indicator of strong character and will weigh heavily on the price I'm willing to pay for an investment.

This is probably why I like managers who focus on increasing intrinsic value and not the stock price. In the long run, the two will meet, a focus on the stock price will only work in the short term though.

I do believe that it's in management's own interest to be transparent, because it encourages people to own the stock on a long term basis and not just trade it on a daily basis. When things don't go well, these are the guys who will buy more because they're betting on the jockey rather than the horse - they know him/her to be honest and transparent and so they will invest their money alongside management's time, effort, and sweat.

rayhaan said...

gr8 ideas ankit! wish there was sum way 2 quantify or atleast sum method 2 tangibly demonstrate dis dan luking at d adjectives in d annual report?
P.s ever thought of starting a blog? I think u ll make a gud blogger

Ankit Gupta said...

Rayhaan - I haven't looked into quantifying the ethics and character of management through the annual report, that's a very good idea actually. I will say that Warren Buffett writes an amazing annual letter that shows his honesty and transparency. Maybe looking for those comments will help? Buffett admits mistakes - look at what it takes for anyone else, even BP, to admit a mistake openly. It should not require our government - just come out and apologize, or state why you're better off with some failures. Maybe one metric is looking at how many footnotes there are of importance that management doesn't discuss on conference calls?

I used to run a business and so when I talk to management, I have a few key questions I'll ask. They are very tough questions and I will keep the answers private, but the people who have honest answers are the folks I'll work hard with. It's a tough filter and unfortunately, there are very few that pass. These questions are not about the business, but themselves.

I will say that the CEO of PRLS has passed this test. He doesn't even return my calls anymore, and I take that as a good sign - he shouldn't until there's some benefit for him.

I'm getting a little off topic, but I want people who have a _long term greed_. I want the greediest of all people, the most selfish managers out there. The good ones know what works and what doesn't. If you become narcissistic, you focus on the short term and end up harming those around you AND yourself. (Accounting fraud, revenue manipulation, etc.) If you're truly the greediest of them all, you will focus on the long term. You aren't in this game to make $5-10M and cash out after pumping the price up, but rather someone who wants to make $50M even if it takes 10x as long. The guy who pumps it up and walks away with $5-10M will not be as successful in the long run, because investors will see his past track record. The manager who took his time building intrinsic value will see long term success that his competitors cannot even imagine.

As I said, I want really greedy people who do what is in their self interest, because they realize that whenever they make a buck, it's because someone else saw value worth more than that buck, so they're both better off. If they have that and it's a long term focus, I'll pay attention.

Investing is a tough thing for me, it's never been easy. My habit is to not swing often, but when I do, to swing large.

Thanks for letting me know about starting a blog - I have a small one that is linked from my posts. It's more of an outlet for me to voice my thoughts on specific concerns rather than a regular task for me, and that's where I don't succeed. I typically work 12-14 hour days (today is 15 already) and so unfortunately, I'm not left with as much time for investing/blogging at this point - I have a lot of learning to do before I can go start an investment fund of some kind, and the blog will probably coincide with that and see more activity, much like Saj's setup. :)

Saj Karsan said...

Hi Andrew,

I believe it is very difficult (moreso than analysts believe) to predict the future, but ACU has clearly managed to do it in the past. What made this a great investment possibility was the fact that a few months ago, the stock price was such that any ROIC over the cost of capital that may occur was offered to the investor for free.