Using the Wrong Framework - Again and Again

Yesterday I did not have enough time to blog on my Biggest Mistake of the Day (BMD) due to some personal issues.  But I have made a commitment to make this a daily process - so this is my make up assignment from yesterday's personal leave.

For ten years, I have been studying American Tower (AMT).  For years I have been interested in this cellphone tower operator.  As cellphone usage increased, cell towers become a "bottleneck" in the business.  It has always had the characteristics of a "toll bridge" but I have not been able to get my pricing correct. 

Initially, I was concerned about "high debt".  My first concern exhibits that I was, again, using the wrong framework from inception.  In the case of an "income statement" based company, debt is definitely a four letter word.  In the world of an "income statement," debt is a way of bringing future earnings into the present.  In our world of fixed costs, a little downturn in revenues has an outsized impact on the bottom line.  Since cyclicality is inherent to capitalism, debt sets up a potential total loss to the equity shareholders.  One way to analyze debt is to ask how many years of earnings it will take to pay it back.  If it's more than seven, look out.

In the case of AMT, my first company review had a number of 100 years to pay it back!  To adjust, I added back depreciation which brought the range back to nearly seven.  That high level of debt made me apprehensive to start with. 

Next I was concerned about the high multiple of earnings.  My first P/E analysis was in excess of 100.  Again, I adjusted by adding back depreciation which gave me a "cash flow" to earnings multiple in excess of 20.  This had all the appearance of a "nose bleed" territory.  I noted, at the time, that valuations were more appropriately focused on revenues, set my prices and waited for the stock price to drop to more attractive levels.

The stock price went up.  Basically straight up.

Finally, I sat down to study where I got it wrong.  It is clear that, once again, I was looking at a "balance sheet" company.  This was not hidden.  In fact, AMT leads its financial statements with its "balance sheet."  AMT was basically borrowing to fund the purchase of assets as a "cellphone" REIT (to which it later converted for tax advantages). 

By viewing AMT as a "balance sheet" company, I would have started with the assets of $8.5 bln, compared it to the debt of $4 bln which would give a "leverage ratio" of 2 or 200%.  From that, I could have estimated the return on assets (adj for depreciation and capital expenditures) and compared that to the cost of liabilities for a net yield on assets.  By studying AMT from that perspective, the extraordinarily high roa assets becomes evident - driving for a higher and more appropriate valuation.

Like PSA, AMT has roughly doubled over the past ten years while the S&P is up 50%.

Using the Wrong Framework - Again

This process of reviewing my Biggest Mistake of the Day (BMD) is going to make for a painful and humiliating 2016.  I'm hoping that I will have less to write about in 2017 as a result.

Today I was reviewing the financial information of Public Storage (PSA) which is the largest owner and operator of self-storage space in the U.S.  PSA operates as a Real Estate Investment Trust (REIT) which means that it does not have to pay taxes at the corporate level as long as it pays all of its earnings to the shareholders. 

(As an aside on this favorable tax treatment, misconceptions have abounded. REIT operators have claimed that they do not benefit from favorable treatment because the dividends are taxed at ordinary income rates that top out at nearly 40% while normally dividends are taxed at 20%.  This logic is faulty because it ignores that the REIT, unlike a corporation, avoids taxes.  A quick comparison.  Company A is a REIT and earns $10 million and pays out all earnings to its shareholders.  Company A pays $0 in taxes and its shareholders (assuming taxable) pay roughly $4 million.  Company B, in the same business, earns $10 million and pays out all earnings to its shareholders.  Company B has a tax bracket of roughly 35%, so it pays $3.5 million in taxes with the remaining $6.5 million in earnings going to shareholders.  These shareholders (again assuming taxable) pay at roughly 20% and so pay $1.3 million.  Company A earnings end up with tax of $4 million and Company B earnings end up with tax of $4.8 million.  REIT operators do have tax advantages.)

Back to my BMD.  I started closely studying PSA in 2005.  I analyzed it with the wrong framework because I focused on traditional income statement measures such as earnings, cash flow and revenues.  I even looked more closely and used a widely- used real estate measure called "funds from operations" (FFO) which is a measure that takes earnings and adds back depreciation and amortization costs.  Using this measure, I estimated that I would pay $36 per share for PSA.  During 2005, the stock's price ranged from $51 to $72.  I thought, "Wow. This stock is pricey!"

Two times a year, every year since then, I have studied the FFO and revised my pricing as the FFO steadily rose.  The only time PSA's stock price went beneath my buy price was briefly in 2009 as the world moved into fire sale mode.  I blamed the pricing disconnect between my pricing and the stock market's pricing on the huge operating margin of 60%+, in a world where I am happy with margins in excess of 12%.  But, as I discussed in my BMD of 1/1/2016, operating margins are not a relevant metric (despite wide usage - even on the quarterly discussions of the company) on a "balance sheet" company.

PSA is definitely a balance sheet company because its service is its balance sheet of a collection of self-storage units.  Once it is clear that a valuation metric needs to use the balance sheet, it is necessary to find the most useful metric.  In the case of PSA, that is not easy.  The balance sheet is primarily made up of real estate whose value is understated due to a combination of historical values and depreciation.  For this reason, book value and equity are misleading. However, with enough digging and without the wrong framework (again), there are sensible ways to get to a valuation.  This is something I should have done earlier. 

Since 2005, PSA stock has risen over 250% in contrast to the stock market, which on average, has risen about 100%.  That's a big penalty for using the wrong framework.

Using the Wrong Framework

I am starting 2016 with a new resolve. This year I will articulate mistakes that I have made and, more importantly, that I am prone to. Warren Buffett, my standing hero, talked about needing to write reports more frequently if he were to start confessing his mistakes. I figure if I just start to blog about the Biggest Mistake of the Day, I'll be on a good start to a book.

Mistakes is a big category - as they say, errors of omission and commission. I am focusing first on errors of commission, although I am not going to give a financial impact tally. All mistakes are costly, unless they lead to greater insights. So here goes - making stepping stones out of all these stumbling blocks.

In financial analysis, the starting point is gathering a tremendous amount of data. Most of this is already gathered for us in the form of quarterly and annual financial statements that are filed with the SEC. This accounted for data becomes the information that we rely on to get to actionable ideas. As financial statements get longer, as information gets more complicated and as life gets busier, we begin to rely on shortcuts or simple frameworks to save time and energy or simply out of sheer laziness.

I don't think my latest Biggest Mistake of the Day was out of sheer laziness, but it was out of a lack of thoughtfulness. In the analysis of financial statements, it is usual for the company and for me to start with a study of the income statement that details the revenues, expenses and net profits of the company. After familiarizing myself with its content, I start to study ratios, such as "operating margin." This is a measure of how much profit (before "external costs" like taxes) is in every revenue dollar. The higher the operating margin, the more likelihood that the company can withstand the brutal forces of capitalism.

Normally the balance sheet follows the income statement. The balance sheet details what the company owns and what it owes and what the difference is - equity. The reason the balance sheet follows the income statement is that the balance sheet is the means of providing the services of the business. However, there are companies in which the balance sheet is not the means of the service, but is the service itself. I believe that companies whose business is the balance sheet should provide that statement first - and sometimes that does happen (although oddly some companies whose balance sheet is the means of the service puts it first; I don't get that).

When a company provides its balance sheet as the service, ratios like "operating margin" do not matter. For example, the margin of profit between a bank's interest income from borrowers and its interest cost for depositors is not really important. If a bank receives $1 million of income and $ .5 million of cost, the $ .5 million does not really tell us anything. Instead, this information must start with the balance sheet by setting the income and expenses as a % of assets. In banks this is regularly done.

However, in the case of insurance companies, which are also balance sheet service providers, the investment community spends a disproportionate time on "operating margin" issues(aka, "combined ratios") which are not really useful. Instead, as in the case of banks, insurance companies should have revenues analyzed as a percentage of assets. In this way, the truly leveraged nature of insurance companies can be grasped and the sensitivity to small changes can be understood.

I personally fell into this trap as I used "debt" measures, "operating margin" ratios Price to Earnings ratios and "combined ratios" to understand and assess the value of many insurance companies. Instead, it is more important to dissect the Return on Assets and connect it to Return on Equity and, finally, to understand its connection to Price to Book ratios. By using the right framework, the sources of an insurance company's strengths and weaknesses should become more apparent.

Assessing Net Profits

After learning what a business does, the first financial measure I try to understand is the history of the company's net profits. The term "net profits" is often used interchangeably with "earnings." (This use of one or more terms to describe the same thing happens frequently in finance and confirms its reputation for imprecision. I would prefer "earnings" connote "taxable income," but that would not fit well with "earnings per share" in which the usage is identical to "net profits.") Both are often used to describe what's left over for the owners after all other bills have been paid. This seemingly straightforward task is complicated by the regularity of one-time exceptions, such as merger fees or tax adjustments or lawsuit costs. In addition, companies put into the "one-time exception" category regular restructuring costs. These patterns are most noticeable in the consumer staples group of companies, marring otherwise consistent earnings. What's an analyst to do? I think that including these charge-offs as a likely occurrence in the future based on past history is the best course of action, even though that often prevents one from "paying up" for the stock.

Wisdom of a Investment Analysis Checklist

Charlie Munger is famous for his "mental model" approach to investing. As part of that, he has recommended that investors have a list of those issues which are pertinent to an investment decision. By identifying the correct answers, he views that a "mental model" is generated which should lead to higher quality decisions. Mohnish Pabrai, another well-known investor, takes this a step further. By emulating the airline industry, he recommends the development a checklist generated by past mistakes. He groups these errors into five "buckets." These "buckets" are made up of 97 specific questions. He does not identify these, but he does reveal the buckets. They are: leverage, management issues, "moat" issues, valuation and personal preferences. The advantage of Pabrai's approach is that it incorporates a less cerebral, more investment specific discipline. The buckets he has identified are replicable with each investor able to fill those buckets with specific questions related to errors of others or himself.

What it's all about- a reminder from BRK

Reviewing the annual report of Berkshire Hathaway (BRK) refreshes my sense of desire for owning wonderful companies. At times, the ups and downs of the markets can dull my senses and redirect my attention to the non-essential aspects of business. In addition, most of the conversations with clients are concerned with the same aspects; few wish to dwell on the real long-term underlying businesses. In contrast, Chairman Buffett lovingly looks at the characteristics of his businesses: their histories, their competitive positions and their leadership. BRK is basically like a Russian doll of sorts - businesses creating cash to buy more businesses which buy more businesses. Essentially portfolio management is the same thing, but market prices all too often become the source because they determine the entrance and exit points. In contrast, Chairman Buffett retains his positions - allowing him to focus in a pure way on the underlying and long-term aspects of the business. The Chairman also focuses attention on earnings, rather than dividends and share price movement. And yet, the siren call of the day is dividend yield or stock price movement. Neither of these factors are even mentioned! He focuses on earnings even on his non-controlled companies (read stocks), breaking down the actual earnings he would be receiving if the companies were controlled. This is an important and refreshing exercise for all of us who own stocks because it brings the focus to that which is important. By reviewing what my personal earnings are from a stock position, as if I were the total owner, is a valuable aid in gaining scale.

What To Make Of TWC's "TV Essentials"?

Time Warner Cable (TWC) is testing a new low-cost level of programming called "TV Essentials." The pricing will be $49.95 per month, which is $10 per month lower than the formerly lowest cost-tier. In order to induce participation, TWC is providing a 12-month promotional rate of $39.95 in New York and $29.95 in Ohio. TWC claims that this programming will assist those who are economically challenged to continue using PayTV. I doubt that this is their primary motivation.

The Essentials package will include 39 cable networks, which have much lower programming costs. The narrowed lineup appears to reduce entertainment costs and almost eliminate expensive sports programming, dropping costs from the approximately $22.50 per month of costs to about $7.50 per month. This $15 per month programming cost reduction means that the $10 per month lower subscriber charge is actually more profitable for TWC.

The movement towards an "a la carte" selection process has been resisted by both content and distribution companies. However, the push by programming companies to increase their revenues is creating incentive for the distribution companies to explore new options. If specific programming costs rise high enough to disrupt subscriptions, distribution companies would be better off to allow subscribers to exclude those higher cost programs with a different package. This is what I believe "TV Essentials" is exploring.

The contract between programming companies and distribution companies forces distribution of programming at the 85-90% participation level. This provision has protected programming companies from being "cherry-picked." However, depending on the performance of the new Essentials package, which relies on the participation flexibility, future contracts may be shaped very differently as they come up for renewal.