After 8 1/2 years on blogger, it's time to move on.
My new posts will be on WordPress at athenacapitalblog.
Please follow me there to keep up with markets, economics, financial planning and all things investing-related.
I look forward to hearing from you there!
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Showing posts with label investing. Show all posts
Showing posts with label investing. Show all posts
Saturday, September 12, 2015
Friday, September 04, 2015
Falling prices are good, unless you are an imminent seller
When the stock market is tanking, like it has been recently, I find many people are scared to talk to me about it. They seem to think that declining stock prices are like a death in the family--a reason to offer condolences.
But, why is that? I don't fret if I go to the grocery store and find prices have fallen 20%. When I go to buy gas, I'm quite happy to find prices have fallen. Why is this so different with stock prices?
After all, I'm a net buyer of investments. Only if I had some imminent plan to sell my stocks because I needed the money very soon would falling prices be a bad thing.
I think most people think I'm putting on a brave face or bucking myself up when I say I'm happy to see stock prices falling. They can't seem to conceive that falling prices are good for buyers of stocks just as it is good for buyers of groceries, gas, cars or even houses.
I think that is because people too closely associate themselves with their current net worth. Instead of conceiving of their net worth as something in flux, that goes up and down like everything in the economy, they feel their current net worth indicates how much they can pull over time.
But, current net worth is a snapshot, not life itself. Just as a picture cannot capture a life, neither can current net worth define your lifetime cash flow.
Even for those close to or in retirement, stock market fluctuations need not be of major concern. If you have money you need to spend next month or next year in the stock market, you are indeed at risk. But you need not bear that risk unless you choose to. Your cash needs for the next three or so years should be in a stable value position, like a bank or money market account, not in the stock market.
Most people who fret over stock market returns don't need that money soon, either. They know they will need it in time, but they don't need it today.
Market volatility and declines are a benefit to the calm investor who knows that current net worth is just a snapshot. Thought of in this way, stock market drops can lead to higher net worth over time and increased cash flows. That is why I'm happy to see the stock market decline, and I think others should be, too.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
But, why is that? I don't fret if I go to the grocery store and find prices have fallen 20%. When I go to buy gas, I'm quite happy to find prices have fallen. Why is this so different with stock prices?
After all, I'm a net buyer of investments. Only if I had some imminent plan to sell my stocks because I needed the money very soon would falling prices be a bad thing.
I think most people think I'm putting on a brave face or bucking myself up when I say I'm happy to see stock prices falling. They can't seem to conceive that falling prices are good for buyers of stocks just as it is good for buyers of groceries, gas, cars or even houses.
I think that is because people too closely associate themselves with their current net worth. Instead of conceiving of their net worth as something in flux, that goes up and down like everything in the economy, they feel their current net worth indicates how much they can pull over time.
But, current net worth is a snapshot, not life itself. Just as a picture cannot capture a life, neither can current net worth define your lifetime cash flow.
Even for those close to or in retirement, stock market fluctuations need not be of major concern. If you have money you need to spend next month or next year in the stock market, you are indeed at risk. But you need not bear that risk unless you choose to. Your cash needs for the next three or so years should be in a stable value position, like a bank or money market account, not in the stock market.
Most people who fret over stock market returns don't need that money soon, either. They know they will need it in time, but they don't need it today.
Market volatility and declines are a benefit to the calm investor who knows that current net worth is just a snapshot. Thought of in this way, stock market drops can lead to higher net worth over time and increased cash flows. That is why I'm happy to see the stock market decline, and I think others should be, too.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, August 28, 2015
What is diversification worth?
In the investing world, diversification has the feel of holy writ. No one conventional will ever question it.
The reality, however, is that diversification is frequently taken out of context and misunderstood.
For example, many investors are sold on the idea that diversification will prevent their portfolios from tanking when markets go haywire. But, this is seldom the case. Perhaps one's portfolio goes down 40% instead of 50%, but that's the best-case scenario at the absolute worst part of a market downturn. How many people are really happy about being momentarily down a little less than the overall market?
I've seen presentations that show much less "reduced volatility"--down 10% instead of 11%--pitched as the holy grail, but I've never heard a client say, "Boy, am I glad I was diversified," with such small differentiation.
As with all things in life, there is a cost to diversification: usually lower returns. The sales pitch is that you give up some return in exchange for lower volatility. That's great, but it must be thoroughly understood that giving up return means less money in retirement. I think many investors would prefer higher volatility and a better retirement, and they should make that choice with a clear idea of what they are choosing. I would happily take 10% more volatility and 10% more income in retirement, and my guess is that I'm not alone.
Diversification is a benefit, but that benefit has limits. A portfolio of 100 stocks should probably be replaced with a low cost index fund. A portfolio that is 80% in your employer's stock is not very smart. Somewhere in between those two extremes is diversification that works for most people.
Diversification works because it removes the consequences of not being omniscient. No one, not even Warren Buffett, knows the future with precision, so that type of diversification is prudent.
That does not mean buy a little of everything and the more the merrier. Over-diversification has huge penalties, too, and that comes in the form of lousy returns.
The benefits and drawbacks of diversification seem clearer after the market has tanked and rebounded like it has over the last week and a half. There was little benefit to being investing in one stock versus another, because they almost all went down and back up together.
The things that did do well, perhaps gold and U.S. Treasuries, either have been or will be terrible investments over 5 to 10 year periods. To gain their benefit in somewhat reduced volatility is to lose future returns that may be worth much more. Perhaps that's not what everyone wants or needs.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
The reality, however, is that diversification is frequently taken out of context and misunderstood.
For example, many investors are sold on the idea that diversification will prevent their portfolios from tanking when markets go haywire. But, this is seldom the case. Perhaps one's portfolio goes down 40% instead of 50%, but that's the best-case scenario at the absolute worst part of a market downturn. How many people are really happy about being momentarily down a little less than the overall market?
I've seen presentations that show much less "reduced volatility"--down 10% instead of 11%--pitched as the holy grail, but I've never heard a client say, "Boy, am I glad I was diversified," with such small differentiation.
As with all things in life, there is a cost to diversification: usually lower returns. The sales pitch is that you give up some return in exchange for lower volatility. That's great, but it must be thoroughly understood that giving up return means less money in retirement. I think many investors would prefer higher volatility and a better retirement, and they should make that choice with a clear idea of what they are choosing. I would happily take 10% more volatility and 10% more income in retirement, and my guess is that I'm not alone.
Diversification is a benefit, but that benefit has limits. A portfolio of 100 stocks should probably be replaced with a low cost index fund. A portfolio that is 80% in your employer's stock is not very smart. Somewhere in between those two extremes is diversification that works for most people.
Diversification works because it removes the consequences of not being omniscient. No one, not even Warren Buffett, knows the future with precision, so that type of diversification is prudent.
That does not mean buy a little of everything and the more the merrier. Over-diversification has huge penalties, too, and that comes in the form of lousy returns.
The benefits and drawbacks of diversification seem clearer after the market has tanked and rebounded like it has over the last week and a half. There was little benefit to being investing in one stock versus another, because they almost all went down and back up together.
The things that did do well, perhaps gold and U.S. Treasuries, either have been or will be terrible investments over 5 to 10 year periods. To gain their benefit in somewhat reduced volatility is to lose future returns that may be worth much more. Perhaps that's not what everyone wants or needs.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, August 21, 2015
The stock market wakes up to global risk
Surprisingly--to me, at least--the market has finally woken up to global economic risks.
The signs were there before: commodity prices tanking, emerging markets in heavy decline, state interventions in Greece and China, accusations of broad corruption in places like Brazil.
The question investors will be asking themselves over the weekend is: is this the beginning of a bear market or just a brief pullback to be bought into?
I'll spoil the suspense: no one knows. Only in hindsight is it clear when bear markets begin versus temporary pullbacks.
What I do know is that a significant pullback or a bigger bear market are both opportunities for investors. During such times, psychology takes over as some people panic, and that means something is being sold too cheaply.
To benefit from such situations, the goal is not to pick the absolute bottom in the stock market or a particular stock, but to know what specific securities are worth--after arduous research--and then to buy accordingly.
When people ask me if such pullbacks scare me, I always say "No!" Such times are great opportunities to benefit from the panic of others.
In other words, I'm excited to go shopping.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
The signs were there before: commodity prices tanking, emerging markets in heavy decline, state interventions in Greece and China, accusations of broad corruption in places like Brazil.
The question investors will be asking themselves over the weekend is: is this the beginning of a bear market or just a brief pullback to be bought into?
I'll spoil the suspense: no one knows. Only in hindsight is it clear when bear markets begin versus temporary pullbacks.
What I do know is that a significant pullback or a bigger bear market are both opportunities for investors. During such times, psychology takes over as some people panic, and that means something is being sold too cheaply.
To benefit from such situations, the goal is not to pick the absolute bottom in the stock market or a particular stock, but to know what specific securities are worth--after arduous research--and then to buy accordingly.
When people ask me if such pullbacks scare me, I always say "No!" Such times are great opportunities to benefit from the panic of others.
In other words, I'm excited to go shopping.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, April 17, 2015
Latest client letter
Athena Capital's 1st quarter 2015 client letter is available.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, February 13, 2015
Stock market up 60% since 2007 peak
Building wealth over time requires the fortitude to stick to your plan.
Colorado Spring's own Allan Roth made this point nicely in a recent Wall Street Journal article. His basic point is that even if you had been unlucky enough to buy at the stock market peak of 2007, your wealth would still be 60% higher now if you had stuck with it.
The problem is that so few stick with it.
Yes, the market went down over 50% from that 2007 peak. But, those losses were temporary. The U.S. businesses underlying the market rebounded and are doing well.
Nothing in life is free. The price of generating good long term investment returns is having the courage to stick to a good plan.
That means you have to be able to ride the market up and down without getting so that scared you sell at the bottom or so euphoric that you don't adjust your portfolio at the top.
Becoming wealthy is not rocket science. Spend 80% of you income, invest the other 20% in the highest performing asset class over time--stocks--and have the intestinal fortitude to stick to that plan over time.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Colorado Spring's own Allan Roth made this point nicely in a recent Wall Street Journal article. His basic point is that even if you had been unlucky enough to buy at the stock market peak of 2007, your wealth would still be 60% higher now if you had stuck with it.
The problem is that so few stick with it.
Yes, the market went down over 50% from that 2007 peak. But, those losses were temporary. The U.S. businesses underlying the market rebounded and are doing well.
Nothing in life is free. The price of generating good long term investment returns is having the courage to stick to a good plan.
That means you have to be able to ride the market up and down without getting so that scared you sell at the bottom or so euphoric that you don't adjust your portfolio at the top.
Becoming wealthy is not rocket science. Spend 80% of you income, invest the other 20% in the highest performing asset class over time--stocks--and have the intestinal fortitude to stick to that plan over time.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, January 30, 2015
Adapting as an investor
I remember well how much I loved to program computers. As a cadet at the Air Force Academy taking lots of astronautical engineering courses, I had to do a lot of computer programming. These projects were very complex, requiring precise calculations (to 8 significant digits) of the velocity and position of satellites, antenna pointing angles, terrestrial positions, etc. They were done on 286 Zenith computers without hard-drives, so some programs could rake as long as 24 hours to run.
I love the process, though. No matter how difficult the problem, I could always solve it. It was like a big puzzle: figure out what part of the program went askew, make changes to that one part and test it repeatedly, and keep doing that until you got it right. Then move on to the next part and repeat until you got it all solved. My classmates were frequently amazed that I would have the projects done weeks in advance. I just loved the process.
Investing doesn't work so easily. The difference is the noisy feedback loop. Orbital mechanics is like clockwork. You know the starting situation, you know the physics, so when something goes off track it is easy to see that it's wrong, and it is easy to figure out where to jump in and fix it.
With investing, the data is much more noisy. By noisy, I mean there are lots of false signals that things are going well when they won't in the long run, and that they are going poorly when they will go well in the long run.
In other words, when you make a change to your investing process, it can take years, perhaps even decades to see if you really have it right. That's not the happy feedback loop of computer programming with instant and clear feedback.
But, that is the nature of the beast. When you see your results aren't doing what you expect, you need to make changes to adapt, and then wait another couple of years to see how that worked.
The process is the same as it is with computer programming, but the signal is very noisy, meaning you don't know if things have actually gone wrong or not, and the feedback loop takes years instead of minutes to complete.
I have to admit, I still love to solve the puzzle. Just like with computer programming, I'm as committed and convinced that I can get it right.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
I love the process, though. No matter how difficult the problem, I could always solve it. It was like a big puzzle: figure out what part of the program went askew, make changes to that one part and test it repeatedly, and keep doing that until you got it right. Then move on to the next part and repeat until you got it all solved. My classmates were frequently amazed that I would have the projects done weeks in advance. I just loved the process.
Investing doesn't work so easily. The difference is the noisy feedback loop. Orbital mechanics is like clockwork. You know the starting situation, you know the physics, so when something goes off track it is easy to see that it's wrong, and it is easy to figure out where to jump in and fix it.
With investing, the data is much more noisy. By noisy, I mean there are lots of false signals that things are going well when they won't in the long run, and that they are going poorly when they will go well in the long run.
In other words, when you make a change to your investing process, it can take years, perhaps even decades to see if you really have it right. That's not the happy feedback loop of computer programming with instant and clear feedback.
But, that is the nature of the beast. When you see your results aren't doing what you expect, you need to make changes to adapt, and then wait another couple of years to see how that worked.
The process is the same as it is with computer programming, but the signal is very noisy, meaning you don't know if things have actually gone wrong or not, and the feedback loop takes years instead of minutes to complete.
I have to admit, I still love to solve the puzzle. Just like with computer programming, I'm as committed and convinced that I can get it right.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, January 23, 2015
The Lessons Of Oil
Not many outside the investing business have heard of Howard Marks. He is a very successful money manager at Oaktree Capital with a reputation built mostly around distressed debt investing.
He also writes very well and publishes Memos that I eagerly read.
His latest is on the fall in the price of oil and what lessons we can learn from it.
I highly recommend it to anyone who wants clear thinking on the subject.
If you don't want to read it, here are some quick highlights:
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
He also writes very well and publishes Memos that I eagerly read.
His latest is on the fall in the price of oil and what lessons we can learn from it.
I highly recommend it to anyone who wants clear thinking on the subject.
If you don't want to read it, here are some quick highlights:
"...what 'everyone knows' is usually unhelpful at best and wrong at worst."
"Not only did the investing herd have the outlook for rates all wrong, but was uniformly inquiring about the wrong thing."
"Asset prices are often set to allow for the risks people are aware of. It's the ones they haven't thought of that can knock the market for a loop."
"Forecasters usually stick too close to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude."
"This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis."
"Most people easily grasp the immediate impact of developments, but few understand the 'second-order' consequences...as well as the third and fourth."
"...it's hard for most people to understand the self-correcting aspects of economic events."
"If you think markets are logical and investors are objective and unemotional, you're in for a lot of surprises."
"A well-known quote from economist Rudiger Dornbusch goes as follows: 'In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.'"
"The key lesson here may be that cartels and other anti-market mechanisms can't hold forever."
"...it's hard to analytically put a price on an asset that doesn't produce income."
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, January 16, 2015
There's no substitute for hard work
When it comes to improving at anything, there is just no substitute for good, old fashioned hard work.
I've been reminded of this lately as I build out my circles of competence through intensive research.
When I started out investing in 1996, I was still working full-time as a pilot in the Air Force and getting my MBA in night school. My research then was heavily focused on quantitative analysis, and my understanding of the qualitative side of investing was slim to none.
As I gained more experience, I also did a lot more research into the qualitative side of research starting in 1998. At that point, my investing results were about as good as the market's, which isn't outstanding, but is quite an accomplishment as a value investor at the end of one of the biggest bull markets in history.
As the dot-com bubble peaked and then exploded from 1999 to 2000, I found myself holding several very under-valued, small brick and mortar companies. Those companies' out-performance was just incredible over the following years.
That was around the time I got out of the Air Force in late 2001 and started as an investing professional. At that point, I had a lot more time to do qualitative research, but my quantitative method was still working so well that I wasn't quite doing the best research I could. Because the quantitative method looked so easy at the time, I didn't see any good reason to dramatically change. If it ain't broke, don't fix it.
I found myself beating the market by over 8% annualized from 1995-2002 (71% more, cumulatively, than market returns) and 1995-2003 (85% more, cumulatively, than market returns). It was like shooting fish in a barrel. Because I was having a harder time finding my quantitative darlings in 2004, I was sitting in a lot of cash, but my returns were still beating the market by over 6.5% annualized over 9 years (76% more, cumulatively, than market returns).
What I didn't realize at the time was that value investing was having it's best run ever from 2000-2005. The quantitative method that had served me so well was about to sunset.
That was when I started my own value investing shop. Bad timing.
I knew the quantitative side wasn't working like it had, but I didn't fully grasp why. As time went by, I worked harder and harder to master the qualitative side of investing, but I wasn't quite getting there because I was trying to do it without really working with as much focus as I needed to.
After beating the market by a small margin from 2005 to 2008, I started to realize I needed a more fundamental make-over of my investment research. Instead of quantitative screens, I needed to figure out which companies I wanted to own, qualitatively, and then figure out what they were worth.
I have been on that path ever since, and I've been working longer and longer hours at it. Getting to know one company, and all its competitors, all the other companies in the industry, and the company's suppliers and buyers, the substitute products that may kill the business, and so on takes many hours of reading, re-reading, learning, researching, analyzing, etc.
When it comes time to improve, nothing really beats hard work. Hard work isn't fun, per se, but it does produce great value. I'm ashamed to say that it took me so long to find and pursue this path, but now that I'm on it, I'm not sure why I thought any other method would work.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
I've been reminded of this lately as I build out my circles of competence through intensive research.
When I started out investing in 1996, I was still working full-time as a pilot in the Air Force and getting my MBA in night school. My research then was heavily focused on quantitative analysis, and my understanding of the qualitative side of investing was slim to none.
As I gained more experience, I also did a lot more research into the qualitative side of research starting in 1998. At that point, my investing results were about as good as the market's, which isn't outstanding, but is quite an accomplishment as a value investor at the end of one of the biggest bull markets in history.
As the dot-com bubble peaked and then exploded from 1999 to 2000, I found myself holding several very under-valued, small brick and mortar companies. Those companies' out-performance was just incredible over the following years.
That was around the time I got out of the Air Force in late 2001 and started as an investing professional. At that point, I had a lot more time to do qualitative research, but my quantitative method was still working so well that I wasn't quite doing the best research I could. Because the quantitative method looked so easy at the time, I didn't see any good reason to dramatically change. If it ain't broke, don't fix it.
I found myself beating the market by over 8% annualized from 1995-2002 (71% more, cumulatively, than market returns) and 1995-2003 (85% more, cumulatively, than market returns). It was like shooting fish in a barrel. Because I was having a harder time finding my quantitative darlings in 2004, I was sitting in a lot of cash, but my returns were still beating the market by over 6.5% annualized over 9 years (76% more, cumulatively, than market returns).
What I didn't realize at the time was that value investing was having it's best run ever from 2000-2005. The quantitative method that had served me so well was about to sunset.
That was when I started my own value investing shop. Bad timing.
I knew the quantitative side wasn't working like it had, but I didn't fully grasp why. As time went by, I worked harder and harder to master the qualitative side of investing, but I wasn't quite getting there because I was trying to do it without really working with as much focus as I needed to.
After beating the market by a small margin from 2005 to 2008, I started to realize I needed a more fundamental make-over of my investment research. Instead of quantitative screens, I needed to figure out which companies I wanted to own, qualitatively, and then figure out what they were worth.
I have been on that path ever since, and I've been working longer and longer hours at it. Getting to know one company, and all its competitors, all the other companies in the industry, and the company's suppliers and buyers, the substitute products that may kill the business, and so on takes many hours of reading, re-reading, learning, researching, analyzing, etc.
When it comes time to improve, nothing really beats hard work. Hard work isn't fun, per se, but it does produce great value. I'm ashamed to say that it took me so long to find and pursue this path, but now that I'm on it, I'm not sure why I thought any other method would work.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, December 12, 2014
The joy of not checking stock prices
I recently finished a wonderful book by Guy Spier, The Education of a Value Investor. In it, he spells out his own history as a value investor and highlights some of the ways he has set up his investing environment to make success more likely.
One of his best suggestions is to check stock prices as infrequently as possible.
This may sound like sacrilege to both professional and layman investors. "How can you react to the market's ebbs and flows if you aren't watching prices all the time?"
The answer is: you shouldn't be reacting to the ebb and flow of prices. A focus on prices going up and down is a distraction to understanding businesses at a fundamental level. Only after you understand a business thoroughly--it's competition, buyers, suppliers, management, potential rivals, possible substitutes--and have figured out what you think a business is worth should you look at the price.
I must admit, I have fallen into the trap of looking at stock prices too frequently. Doing so is very distracting. Instead of focusing on understanding a business and its value, you get dragged into looking at the stock price and begin to impart interpretations into why the price has gone down or up. Every moment spent trying to understand those senseless moves are moments not spent understanding the business.
I have gone the last two weeks without checking stock prices. That doesn't mean I don't have mechanisms set up to react to low or high prices on businesses I already understand, it just means I don't look at daily price moves and how they compare to the market that day. The result is that I've gotten more fundamental research done and I feel more sober-minded in trying to understand the businesses I'm researching.
In time, I believe I'll also have better investment returns to show for it.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
One of his best suggestions is to check stock prices as infrequently as possible.
This may sound like sacrilege to both professional and layman investors. "How can you react to the market's ebbs and flows if you aren't watching prices all the time?"
The answer is: you shouldn't be reacting to the ebb and flow of prices. A focus on prices going up and down is a distraction to understanding businesses at a fundamental level. Only after you understand a business thoroughly--it's competition, buyers, suppliers, management, potential rivals, possible substitutes--and have figured out what you think a business is worth should you look at the price.
I must admit, I have fallen into the trap of looking at stock prices too frequently. Doing so is very distracting. Instead of focusing on understanding a business and its value, you get dragged into looking at the stock price and begin to impart interpretations into why the price has gone down or up. Every moment spent trying to understand those senseless moves are moments not spent understanding the business.
I have gone the last two weeks without checking stock prices. That doesn't mean I don't have mechanisms set up to react to low or high prices on businesses I already understand, it just means I don't look at daily price moves and how they compare to the market that day. The result is that I've gotten more fundamental research done and I feel more sober-minded in trying to understand the businesses I'm researching.
In time, I believe I'll also have better investment returns to show for it.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, November 14, 2014
How to make a fortune
The Forbes 400 list of richest Americans came out recently (you can see it here).
I enjoy looking through the list each year (and have for 20) to better understand how people become wealthy. We are not talking about the mass affluent, the affluent, high net worth, or even ultra high net worth, here. We are talking about billionaires. The highest on the list is at $81 billion and the lowest is at $1.55 billion. These people haven't just become wealthy, they have become fabulously so. How?
That's the question I ask myself each year, and this year I decided to keep track.
I wasn't interested in finding out how many inherited wealth. Inheritance does not create wealth. With this in mind, I kept track of how the Forbes 400 made their fortunes.
One category is entrepreneurship. These are people who come up with an idea and then put it to work by starting their own company. The Forbes 400 is dominated by these folks at 52% of the list. Some did it through technology, others through retail, some with restaurants, some with medical devices and pharmaceutical products. These people create the new products and services we all enjoy. They had to be smart and hard working to succeed, but also had some good luck. Think Bill Gates, Larry Ellison, Sam Walton, Michael Bloomberg, Mark Zuckerberg, Larry Page and Sergey Brin. Not only do the dominate the list as a whole, they dominate the highest rungs of the list.
Next are the business fortunes, clocking in at 20%. These are people who instead of starting companies, either worked at businesses or bought businesses from others and put themselves in charge. Looking over the list, I see that they frequently fix broken businesses or make okay businesses great. Think Steve Ballmer at Microsoft, the Koch brothers, Rupert Murdoch, Richard Kinder, George Kaiser and Meg Whitman.
Next are the investing fortunes, coming in at 19%. These are people who don't start or run businesses, per se, but invest others and their own in such businesses. They may influence the businesses, but they don't run them. In some cases, they are completely separate from the business. This can be done through a holding company, with a hedge fund, through private equity, or running money through mutual funds. Think Warren Buffett, Carl Icahn, George Soros, Len Blavatnik, Ray Dalio, Ron Perelman, John Paulson and James Simons.
Next are the real estate fortunes, coming in at 9%. These fortunes were built by buying real estate--usually with leverage--and rolling the dollars made back into more real estate. These fortunes are high risk/high reward because of the leverage usually required, but also require smart business moves and an understanding of where and how real estate will succeed. Many Americans, I think, over-estimate how successful this strategy is. The list includes names like Donald Bren, Andrew Beal, Stephen Ross, Richard LeFrakand and Leonard Stern.
I was surprised to see there is a lawyer on the list: 1. So, being a lawyer comes in at 0.3%. Way to go Joe Jamail: The King of Torts.
There you have it. Entrepreneurs top the list. You can make a massive fortune by finding an unmet market need and meeting it through hard work, long hours, and a good piece of luck. Or, you can be a successful businessperson joining the right company at the right time or by fixing broken or sub-par businesses. Or, you can invest other people's money through lots of research and a knack for understanding when markets become irrational. Or, you buy and sell real estate with a lot of debt, some good luck, and a keen sense of location, location, location.
Or, you can be the King of Torts.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
I enjoy looking through the list each year (and have for 20) to better understand how people become wealthy. We are not talking about the mass affluent, the affluent, high net worth, or even ultra high net worth, here. We are talking about billionaires. The highest on the list is at $81 billion and the lowest is at $1.55 billion. These people haven't just become wealthy, they have become fabulously so. How?
That's the question I ask myself each year, and this year I decided to keep track.
I wasn't interested in finding out how many inherited wealth. Inheritance does not create wealth. With this in mind, I kept track of how the Forbes 400 made their fortunes.
One category is entrepreneurship. These are people who come up with an idea and then put it to work by starting their own company. The Forbes 400 is dominated by these folks at 52% of the list. Some did it through technology, others through retail, some with restaurants, some with medical devices and pharmaceutical products. These people create the new products and services we all enjoy. They had to be smart and hard working to succeed, but also had some good luck. Think Bill Gates, Larry Ellison, Sam Walton, Michael Bloomberg, Mark Zuckerberg, Larry Page and Sergey Brin. Not only do the dominate the list as a whole, they dominate the highest rungs of the list.
Next are the business fortunes, clocking in at 20%. These are people who instead of starting companies, either worked at businesses or bought businesses from others and put themselves in charge. Looking over the list, I see that they frequently fix broken businesses or make okay businesses great. Think Steve Ballmer at Microsoft, the Koch brothers, Rupert Murdoch, Richard Kinder, George Kaiser and Meg Whitman.
Next are the investing fortunes, coming in at 19%. These are people who don't start or run businesses, per se, but invest others and their own in such businesses. They may influence the businesses, but they don't run them. In some cases, they are completely separate from the business. This can be done through a holding company, with a hedge fund, through private equity, or running money through mutual funds. Think Warren Buffett, Carl Icahn, George Soros, Len Blavatnik, Ray Dalio, Ron Perelman, John Paulson and James Simons.
Next are the real estate fortunes, coming in at 9%. These fortunes were built by buying real estate--usually with leverage--and rolling the dollars made back into more real estate. These fortunes are high risk/high reward because of the leverage usually required, but also require smart business moves and an understanding of where and how real estate will succeed. Many Americans, I think, over-estimate how successful this strategy is. The list includes names like Donald Bren, Andrew Beal, Stephen Ross, Richard LeFrakand and Leonard Stern.
I was surprised to see there is a lawyer on the list: 1. So, being a lawyer comes in at 0.3%. Way to go Joe Jamail: The King of Torts.
There you have it. Entrepreneurs top the list. You can make a massive fortune by finding an unmet market need and meeting it through hard work, long hours, and a good piece of luck. Or, you can be a successful businessperson joining the right company at the right time or by fixing broken or sub-par businesses. Or, you can invest other people's money through lots of research and a knack for understanding when markets become irrational. Or, you buy and sell real estate with a lot of debt, some good luck, and a keen sense of location, location, location.
Or, you can be the King of Torts.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Thursday, October 30, 2014
John Deere: expected returns and potential downside
(Full disclosure: my clients and I own shares of Deere.)
In preceding articles, I've covered Deere's (DE) general situation, competition, economics, management, and opportunities & risks. Now it's time to put those thoughts together with some math to figure out what kind of returns can be expected from John Deere.
Before I jump in, I want to make it clear that my expected return discussion is based on the long run. For that reason, it is important to read the full article and see the second half, where I talk about how bad valuation can get in between now and the long run. Caveat emptor.
Long term expected return
My approach to projecting long term returns is to look at long term trends and normalize that for cyclical factors. I want to know what long term, normalized sales per share, net margins, growth and multiples are so that I can estimate a five year price (not necessarily as a five year price target, but a normalized level for price in five years).
Sales per share
In Deere's case, sales growth from 1982 to 2013 (using the exponential fit function in Excel) is quite stable (96.7% R-squared function, Excel). If it weren't, I wouldn't use it. Deviating from this fit would have to assume a secular change in the farming or farm equipment market different from anything seen from 1982 to 2013. A fit from 1982 to 2013 shows a $33.8 billion normalized sales level a year from now. Applying 377 fully diluted shares (I take basic shares and add all options, restricted stock, etc. to that number) to that sales level implies around $90 in sales per share.
To adjust for the ethanol boom, I also did a fit from 1982-2004, and that showed sales per share of $75. To estimate what things would look like if the last 10 years were the trend going forward, I also did a fit from 2004-2013, and that showed sales per share of $95. Now, I have estimates for normalized sales per share with low, average and high trends in mind.
Net margin
Net margins at Deere have moved a round a lot over the last 32 years. The median net margin over that time was 5.9%, but it has also been steadily trending up (due both to Deere being better managed and a nice tailwind from farming growth scaling up). Below are the the longer to shorter term median net margins:
Growth
I break growth into three parts: sales growth, margin growth, and share growth/buybacks. For Deere, the historic growth trend has been 7.5% (the first fit referred to above). Looking at the trend from 1982-2004 (pre ethanol boom), the trend was 6.7%. These numbers were confirmed by looking at long term averages as well, which show and average of 7.6% and a median of 9.8%. For my estimation, I will use a low end sales growth estimate of 5%, a mid point of 6.5%, and a high end of 8% (I'm being conservative on this because I know the ethanol boom of the last 9 years won't be repeated).
Margin growth has varied widely over the last 32 years, but has generally trended up at a median rate of 1.6%. I think it would be imprudent to assume that Deere can recreate that accomplishment in the coming 5 years, so I will use a low end of 0% margin growth, a mid point of 0.5%, and a high end of 1% (I'm still assuming management can bring margins up with scale, manufacturing efficiencies, etc.).
Share count has also varied a lot over the last 32 years. In the more distant past, share count actually grew, but as management has refocused on building shareholder wealth, and been incentivized to do so, share count has declined at a median rate of 2.3% over the last 18 years and 3.9% over the last 10 years. I don't expect that high rate to continue assuming the agriculture market cools off, but I do expect a low end of 0% buybacks, a mid point of 0.5%, and a high end of 1%.
Putting together these pieces, I'm estimating 5% (5+0+0), 7.5% (6.5+0.5+.05) and 10% (8+1+1) growth rates at the low, mid and high ends.
Multiple
What multiple of earnings has the market been willing to pay for Deere? That has fluctuated widely, too. Because Deere is a cyclical business, investors have been willing to pay high multiples when earnings were low and low multiples when earnings were high. Multiples have also trended up over time as Deere has become a better business with wider profit margins. Given that, the median, low and high multiple to earnings over the last 32 years has been 10.5x and 16.5x, with 13.5x in the middle, so that is what I will use.
Expected returns
If you put together all the low, medium and high end assumptions above over a five year period, plus dividends growing at the same rate as sales per share and an $85 price tag on Deere, you get return expectations (annualized) of -2.9% 11.2% and 23.2%. Now, I assign a range of probabilities to those returns to come up with expected returns. Assuming a probability of 45% and 20% for the low end, 50% to 65% for the mid range, and 5% to 15% for the high end, I come up with a return expectation of 5.5% to 10.2%. (If you plug different numbers into the framework above, you can come up with vastly different results, so a lot depends on your assumptions being valid, or at least reasonable.)
This may not be the barn-burning return you expected, but it looks good compared to my projection of a 3.4% annualized return from the S&P 500 (at $1,982.30) over the next give years.
Keep in mind that my 5-10% return expectation on Deere is a long term projection. The path to that return may be bumpy, as I highlight below in my section on how bad things can get.
How low can you go?
To buy a cyclical company like Deere, it's not enough to have an idea what average future returns may be. You must also be ready to ride the cycle down to an uncomfortably low point, and be willing to buy more on that difficult trip down. This is particularly important with Deere because a long agricultural boom is coming to an end and farm equipment sales are clearly already tumbling. So, how bad can things get for Deere's stock price in between now and the long term?
One way to look at how low Deere's stock price can go is to look at multi-year sales per share (I use sales per share to account for the fact that earnings per share can get so low as to make earnings multiples meaningless) compared to the lowest multiples that have been experienced historically. Looking at an average of 3 year of sales per share relative to lowest annual prices, I can see that Deere got down to a 0.2x multiple of sales per share in 1986. Looking at 5 year average sales per share, 7 year, and 10 year, I see multiples of 0.4x, 0.5x and 0.5x. Below are the prices that Deere could get to, accordingly, from around $85 today:
Another way to think about how low Deere's price can get is to look at prior peak to trough sales declines and apply low end multiples. Between 1982 and 1986, Deere's declined peak to trough by 24%. From 1990-1992, 16%; from 1998-1999, 19%; from 2008-2009, 21%. The 1982-1986 scenario, the worst I have on record, would see Deere's 7/31/13 LTM peak sales go from $35,250 to $26,920, or to $71 per share. The 1990 drop, the least bad drop, would pull sales down to $29,573 or $79 per share. Applying the 25th-percentile low multiple (0.5x in both cases) to those figures gives share prices of $35.50 and $39.50.
A final way to prepare for low prices is to look at my normalized sales fits above and compare them to the lowest multiples of sales seen historically. The trough multiples on normalized sales were 0.2x sales per share in 1986, 0.4x in 1992, 0.6x in 1999, and 0.4x in 2009. Applying those multiples to the fitted sales per share above of $75, $90 and $95 gives price bottoms of $15-19, $30-38 and $45-47. (Once again, keep in mind I consider the 1986 scenario quite unlikely.)
As I hope I've made clear, although I expect Deere to provide good long term returns, the path to those returns may be quite uncomfortable. Such is the nature of cyclical companies.
The upside is that Deere's price getting that low would likely generate truly amazing returns going forward (as they did for smart investors who bought in 1986, 1992, 1998 and 2009). Prices may never get that low, but it is best to prepare for such an eventuality even if it never occurs. Forewarned is forearmed.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
In preceding articles, I've covered Deere's (DE) general situation, competition, economics, management, and opportunities & risks. Now it's time to put those thoughts together with some math to figure out what kind of returns can be expected from John Deere.
Before I jump in, I want to make it clear that my expected return discussion is based on the long run. For that reason, it is important to read the full article and see the second half, where I talk about how bad valuation can get in between now and the long run. Caveat emptor.
Long term expected return
My approach to projecting long term returns is to look at long term trends and normalize that for cyclical factors. I want to know what long term, normalized sales per share, net margins, growth and multiples are so that I can estimate a five year price (not necessarily as a five year price target, but a normalized level for price in five years).
Sales per share
In Deere's case, sales growth from 1982 to 2013 (using the exponential fit function in Excel) is quite stable (96.7% R-squared function, Excel). If it weren't, I wouldn't use it. Deviating from this fit would have to assume a secular change in the farming or farm equipment market different from anything seen from 1982 to 2013. A fit from 1982 to 2013 shows a $33.8 billion normalized sales level a year from now. Applying 377 fully diluted shares (I take basic shares and add all options, restricted stock, etc. to that number) to that sales level implies around $90 in sales per share.
To adjust for the ethanol boom, I also did a fit from 1982-2004, and that showed sales per share of $75. To estimate what things would look like if the last 10 years were the trend going forward, I also did a fit from 2004-2013, and that showed sales per share of $95. Now, I have estimates for normalized sales per share with low, average and high trends in mind.
Net margin
Net margins at Deere have moved a round a lot over the last 32 years. The median net margin over that time was 5.9%, but it has also been steadily trending up (due both to Deere being better managed and a nice tailwind from farming growth scaling up). Below are the the longer to shorter term median net margins:
- 30 year: 6.1%
- 25 year: 7.2%
- 20 year: 7.7%
- 10 year: 7.7%
- 5 year: 8.2%
- 3 year: 9.2%
Growth
I break growth into three parts: sales growth, margin growth, and share growth/buybacks. For Deere, the historic growth trend has been 7.5% (the first fit referred to above). Looking at the trend from 1982-2004 (pre ethanol boom), the trend was 6.7%. These numbers were confirmed by looking at long term averages as well, which show and average of 7.6% and a median of 9.8%. For my estimation, I will use a low end sales growth estimate of 5%, a mid point of 6.5%, and a high end of 8% (I'm being conservative on this because I know the ethanol boom of the last 9 years won't be repeated).
Margin growth has varied widely over the last 32 years, but has generally trended up at a median rate of 1.6%. I think it would be imprudent to assume that Deere can recreate that accomplishment in the coming 5 years, so I will use a low end of 0% margin growth, a mid point of 0.5%, and a high end of 1% (I'm still assuming management can bring margins up with scale, manufacturing efficiencies, etc.).
Share count has also varied a lot over the last 32 years. In the more distant past, share count actually grew, but as management has refocused on building shareholder wealth, and been incentivized to do so, share count has declined at a median rate of 2.3% over the last 18 years and 3.9% over the last 10 years. I don't expect that high rate to continue assuming the agriculture market cools off, but I do expect a low end of 0% buybacks, a mid point of 0.5%, and a high end of 1%.
Putting together these pieces, I'm estimating 5% (5+0+0), 7.5% (6.5+0.5+.05) and 10% (8+1+1) growth rates at the low, mid and high ends.
Multiple
What multiple of earnings has the market been willing to pay for Deere? That has fluctuated widely, too. Because Deere is a cyclical business, investors have been willing to pay high multiples when earnings were low and low multiples when earnings were high. Multiples have also trended up over time as Deere has become a better business with wider profit margins. Given that, the median, low and high multiple to earnings over the last 32 years has been 10.5x and 16.5x, with 13.5x in the middle, so that is what I will use.
Expected returns
If you put together all the low, medium and high end assumptions above over a five year period, plus dividends growing at the same rate as sales per share and an $85 price tag on Deere, you get return expectations (annualized) of -2.9% 11.2% and 23.2%. Now, I assign a range of probabilities to those returns to come up with expected returns. Assuming a probability of 45% and 20% for the low end, 50% to 65% for the mid range, and 5% to 15% for the high end, I come up with a return expectation of 5.5% to 10.2%. (If you plug different numbers into the framework above, you can come up with vastly different results, so a lot depends on your assumptions being valid, or at least reasonable.)
This may not be the barn-burning return you expected, but it looks good compared to my projection of a 3.4% annualized return from the S&P 500 (at $1,982.30) over the next give years.
Keep in mind that my 5-10% return expectation on Deere is a long term projection. The path to that return may be bumpy, as I highlight below in my section on how bad things can get.
How low can you go?
To buy a cyclical company like Deere, it's not enough to have an idea what average future returns may be. You must also be ready to ride the cycle down to an uncomfortably low point, and be willing to buy more on that difficult trip down. This is particularly important with Deere because a long agricultural boom is coming to an end and farm equipment sales are clearly already tumbling. So, how bad can things get for Deere's stock price in between now and the long term?
One way to look at how low Deere's stock price can go is to look at multi-year sales per share (I use sales per share to account for the fact that earnings per share can get so low as to make earnings multiples meaningless) compared to the lowest multiples that have been experienced historically. Looking at an average of 3 year of sales per share relative to lowest annual prices, I can see that Deere got down to a 0.2x multiple of sales per share in 1986. Looking at 5 year average sales per share, 7 year, and 10 year, I see multiples of 0.4x, 0.5x and 0.5x. Below are the prices that Deere could get to, accordingly, from around $85 today:
- 3 year sales per share, 0.2x multiple: $17
- 5 year sales per share, 0.4x multiple: $29
- 7 year sales per share, 0.5x multiple: $33
- 10 year sales per share: 0.5x multiple: $29
Another way to think about how low Deere's price can get is to look at prior peak to trough sales declines and apply low end multiples. Between 1982 and 1986, Deere's declined peak to trough by 24%. From 1990-1992, 16%; from 1998-1999, 19%; from 2008-2009, 21%. The 1982-1986 scenario, the worst I have on record, would see Deere's 7/31/13 LTM peak sales go from $35,250 to $26,920, or to $71 per share. The 1990 drop, the least bad drop, would pull sales down to $29,573 or $79 per share. Applying the 25th-percentile low multiple (0.5x in both cases) to those figures gives share prices of $35.50 and $39.50.
A final way to prepare for low prices is to look at my normalized sales fits above and compare them to the lowest multiples of sales seen historically. The trough multiples on normalized sales were 0.2x sales per share in 1986, 0.4x in 1992, 0.6x in 1999, and 0.4x in 2009. Applying those multiples to the fitted sales per share above of $75, $90 and $95 gives price bottoms of $15-19, $30-38 and $45-47. (Once again, keep in mind I consider the 1986 scenario quite unlikely.)
As I hope I've made clear, although I expect Deere to provide good long term returns, the path to those returns may be quite uncomfortable. Such is the nature of cyclical companies.
The upside is that Deere's price getting that low would likely generate truly amazing returns going forward (as they did for smart investors who bought in 1986, 1992, 1998 and 2009). Prices may never get that low, but it is best to prepare for such an eventuality even if it never occurs. Forewarned is forearmed.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, October 24, 2014
John Deere's opportunities and risks
(Full disclosure: my clients and I own shares of Deere (DE))
John Deere faces significant opportunities and risks that must be considered before a proper valuation can be done.
Opportunities
The biggest opportunity John Deere faces is booming growth for food in developing and emerging markets. This subject has been covered significantly by others, but I'd like to put a couple of data points out there for consideration. Middle class growth over the next 15 years from places like China, India, Indonesia, Brazil, Pakistan, Mexico, the Philippines, Vietnam, Bangladesh, Nigeria, etc. will be staggering. That middle class is expected to go from 29% of world population in 2008 to 50% by 2030 (Goldman Sachs, 2008). That larger middle class will lead to higher crop production over time and the need for higher efficiency farm equipment like Deere produces. Higher incomes will also lead to higher protein consumption in the form of meat like beef, pork, chicken, fish, etc. (as it has for every country that has achieved middle class income). It takes 2-6 times the pounds of crops to produce an equal pound of meat (Wikipedia, feed conversion ratio). The shift in middle class diets towards more meat consumption will also lead to the need for higher and more efficient crop production the world over.
A second opportunity for Deere is to boost the lower productivity of many farmers in the world. In corn production, Canada is the second most efficient producer to the U.S. at 96% and Nigeria is only 18% as efficient (looking at production relative to acres harvested, USDA data on Deere's website). With soybeans, Brazil is the most efficient producer, 3% more efficient than the U.S., with Canada at 98% U.S. efficiency and India at 33%. With wheat, the E.U., China, Canada and Ukraine are more efficient than the U.S., but Kazakhstan is only 34% as efficient. The rest of the world can benefit from Deere's high efficiency farming equipment in order to produce the growing demand for more food.
Although Deere dominates in manufacturing large tractors and combines for row crop production, they also have the opportunity to grow share and efficiency in building equipment for other crops, such as cotton, sugarcane, rice, etc. It may take time to build such expertise, but the returns for such effort, especially over the rest of the world, are great.
John Deere isn't just a farm equipment manufacturer, they also make construction and forestry equipment. That division has been in a major slump as both the U.S. and the rest of the world has cut back dramatically on construction and forestry markets. But, the good news for Deere is that such markets are coming back and will come back to a normalized level over time. This recovery will, no doubt, come in fits and starts, but Deere has the opportunity to profit from significantly higher revenues and profit margins as those markets recover.
A more defensive opportunity for Deere comes from its finance arm. Although this business is likely to decline over time (see risks below), it will decline more slowly than new equipment sales, and that will dampen earnings volatility over the full cycle.
Finally, Deere's businesses have a significant service parts business. Although this is a smaller part of Deere's business, it is profitable and much more stable than selling original equipment.
Risks
An understanding of Deere's opportunities must be balanced against a solid understanding of its risks. Most of these risks relate to the long cyclical boom of farming over the last 5-10 years.
The ethanol production boom has led to great mal-investment over the last 5-10 years. By mal-investment, I'm referring to the Austrian economics term for investment that results from government manipulation of markets. Much more corn has been planted and harvested in order to meet government demands for ethanol production. That artificial demand has led more farmers to buy more equipment than they otherwise would have. Although Deere has benefited from that over the last 5-10 years (and you can see it in their volumes, margins and returns on capital over that time), they have also necessarily overbuilt production capabilities and pulled demand from the future. The boozy boom of the last decade is likely to turn into a nasty hangover over the next decade.
This long boom will take years to work out and for Deere to re-achieve economic equilibrium and then restore normalized growth. That means production will likely need to be cut significantly with a resultant decline in volumes, margins and returns on capital.
The long boom has also resulted in one of the youngest, most productive tractor and combine fleets in history. Farmers making less money (due to lower crop prices caused by supply getting ahead of underlying demand) will be reluctant to replace or even repair such young equipment. This will create the same headwind referred to in the two paragraphs above.
The farm equipment market depends heavily on government financing, especially in places like Brazil. Another risk to Deere is that such funding dries up as many emerging, developing and developed market governments try to right their own fiscal problems. This could create an additional headwind to production volumes and profitability.
John Deere also specializes in large, hyper-efficient farm equipment that most of the developing world is not as willing or ready to purchase. It will take Deere time to build up profitability of smaller tractors and harvesters and and adapt them to new local markets. Added to this, Deere doesn't possess the same advantages in smaller scale farm equipment that they possess in large equipment, thus under-cutting one of their key competitive advantages.
Although Deere's finance arm dampens earnings volatility over the full cycle, it will also become a headwind over time as less new equipment is financed (thus shrinking the earning portfolio) and less profitable farmers default on their financing. Added to this, such problems will generate more used equipment to compete with Deere's new equipment. Financing equipment sales is a double-edged sword that will be considered an increasing risk over time (until, that is, market equilibrium is restored).
Reviewing the opportunities above, you can see there are mostly secular growth opportunities offsetting cyclical decline risks. How these two forces play against each other is another risk for Deere. Will secular growth overcome the downturn due to mal-investment and a return to normalized economics? Or will it take time for secular growth to overcome the cyclical headwinds of over-production? I don't know the answer, but I know it is a risk for Deere as an investment. I would expect the cyclical headwind to prevail over the short to intermediate term and for the secular tailwind to assert itself over the intermediate to long term.
Next week, I will take a hack at Deere's valuation, keeping in mind the risk and opportunities highlighted above.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
John Deere faces significant opportunities and risks that must be considered before a proper valuation can be done.
Opportunities
The biggest opportunity John Deere faces is booming growth for food in developing and emerging markets. This subject has been covered significantly by others, but I'd like to put a couple of data points out there for consideration. Middle class growth over the next 15 years from places like China, India, Indonesia, Brazil, Pakistan, Mexico, the Philippines, Vietnam, Bangladesh, Nigeria, etc. will be staggering. That middle class is expected to go from 29% of world population in 2008 to 50% by 2030 (Goldman Sachs, 2008). That larger middle class will lead to higher crop production over time and the need for higher efficiency farm equipment like Deere produces. Higher incomes will also lead to higher protein consumption in the form of meat like beef, pork, chicken, fish, etc. (as it has for every country that has achieved middle class income). It takes 2-6 times the pounds of crops to produce an equal pound of meat (Wikipedia, feed conversion ratio). The shift in middle class diets towards more meat consumption will also lead to the need for higher and more efficient crop production the world over.
A second opportunity for Deere is to boost the lower productivity of many farmers in the world. In corn production, Canada is the second most efficient producer to the U.S. at 96% and Nigeria is only 18% as efficient (looking at production relative to acres harvested, USDA data on Deere's website). With soybeans, Brazil is the most efficient producer, 3% more efficient than the U.S., with Canada at 98% U.S. efficiency and India at 33%. With wheat, the E.U., China, Canada and Ukraine are more efficient than the U.S., but Kazakhstan is only 34% as efficient. The rest of the world can benefit from Deere's high efficiency farming equipment in order to produce the growing demand for more food.
Although Deere dominates in manufacturing large tractors and combines for row crop production, they also have the opportunity to grow share and efficiency in building equipment for other crops, such as cotton, sugarcane, rice, etc. It may take time to build such expertise, but the returns for such effort, especially over the rest of the world, are great.
John Deere isn't just a farm equipment manufacturer, they also make construction and forestry equipment. That division has been in a major slump as both the U.S. and the rest of the world has cut back dramatically on construction and forestry markets. But, the good news for Deere is that such markets are coming back and will come back to a normalized level over time. This recovery will, no doubt, come in fits and starts, but Deere has the opportunity to profit from significantly higher revenues and profit margins as those markets recover.
A more defensive opportunity for Deere comes from its finance arm. Although this business is likely to decline over time (see risks below), it will decline more slowly than new equipment sales, and that will dampen earnings volatility over the full cycle.
Finally, Deere's businesses have a significant service parts business. Although this is a smaller part of Deere's business, it is profitable and much more stable than selling original equipment.
Risks
An understanding of Deere's opportunities must be balanced against a solid understanding of its risks. Most of these risks relate to the long cyclical boom of farming over the last 5-10 years.
The ethanol production boom has led to great mal-investment over the last 5-10 years. By mal-investment, I'm referring to the Austrian economics term for investment that results from government manipulation of markets. Much more corn has been planted and harvested in order to meet government demands for ethanol production. That artificial demand has led more farmers to buy more equipment than they otherwise would have. Although Deere has benefited from that over the last 5-10 years (and you can see it in their volumes, margins and returns on capital over that time), they have also necessarily overbuilt production capabilities and pulled demand from the future. The boozy boom of the last decade is likely to turn into a nasty hangover over the next decade.
This long boom will take years to work out and for Deere to re-achieve economic equilibrium and then restore normalized growth. That means production will likely need to be cut significantly with a resultant decline in volumes, margins and returns on capital.
The long boom has also resulted in one of the youngest, most productive tractor and combine fleets in history. Farmers making less money (due to lower crop prices caused by supply getting ahead of underlying demand) will be reluctant to replace or even repair such young equipment. This will create the same headwind referred to in the two paragraphs above.
The farm equipment market depends heavily on government financing, especially in places like Brazil. Another risk to Deere is that such funding dries up as many emerging, developing and developed market governments try to right their own fiscal problems. This could create an additional headwind to production volumes and profitability.
John Deere also specializes in large, hyper-efficient farm equipment that most of the developing world is not as willing or ready to purchase. It will take Deere time to build up profitability of smaller tractors and harvesters and and adapt them to new local markets. Added to this, Deere doesn't possess the same advantages in smaller scale farm equipment that they possess in large equipment, thus under-cutting one of their key competitive advantages.
Although Deere's finance arm dampens earnings volatility over the full cycle, it will also become a headwind over time as less new equipment is financed (thus shrinking the earning portfolio) and less profitable farmers default on their financing. Added to this, such problems will generate more used equipment to compete with Deere's new equipment. Financing equipment sales is a double-edged sword that will be considered an increasing risk over time (until, that is, market equilibrium is restored).
Reviewing the opportunities above, you can see there are mostly secular growth opportunities offsetting cyclical decline risks. How these two forces play against each other is another risk for Deere. Will secular growth overcome the downturn due to mal-investment and a return to normalized economics? Or will it take time for secular growth to overcome the cyclical headwinds of over-production? I don't know the answer, but I know it is a risk for Deere as an investment. I would expect the cyclical headwind to prevail over the short to intermediate term and for the secular tailwind to assert itself over the intermediate to long term.
Next week, I will take a hack at Deere's valuation, keeping in mind the risk and opportunities highlighted above.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, October 10, 2014
John Deere: Management
(Full disclosure: my clients and I own shares of Deere)
After covering John Deere's (DE) general situation, competitive position, and economics, I will now take a hard look at management. Specifically, I want to examine the board of directors, executive team, and then evaluate both.
Board of Directors
Deere's board consists of 11 members, which I think it too big. It consists of the CEO/chairman, an insider, 5 major executives (from Lockheed Martin, DuPont, Rockwell Collins, BMW, Cargill), 2 minor executives (Springs Company, New Vernon Capital), one professor, and one former general.
I like to see representation by executives who have real experience allocating capital, managing people and making hard decisions. Many of Deere's board members serve on several other boards, though, so I wonder how focused they are on Deere. Professors are very intelligent people with unique knowledge, but that doesn't qualify them to judge a business, capital allocation, or senior executives (any more than being an investor qualifies me to write treatises on economics). The same can be said for a retired general (as an ex-Air Force officer, that's not blind prejudice).
The average pay for the board of directors (not including chair/CEO) is $230,000 per year. That is not a large sum given the size and prominence of Deere.
Directors own anywhere from $299,000 in Deere shares to $2.66 million. 7 members own more share value than 3 years worth of board salary, which I think makes them act more like owners. The other four own 1-3 times board salary, which makes them more inclined to vote their salary than their ownership. Unfortunately, board ownership is almost exclusively from restricted stock awards. In other words, the board hasn't invested their own hard-earned money in Deere like investors.
Deere's board resembles most large company boards, with lots of prominent members--some with business experience, some not--handsomely paid and with little ownership. I'd prefer members who've put their own dollars on the line like investors, and perhaps a couple of directors who are from the asset management world (private equity, money management, etc.). Instead, Deere's board is filled with executives who are likely to feel sympathy with Deere's management where I'd prefer some people willing to hold management accountable to tough standards.
Executive Team
The top five members of Deere's executive team average 28 years at Deere. The CEO has been there 39 years and the CFO is the newbie at 18. I prefer management teams that are brought up in the business, especially a cyclical business like Deere's. Each manager has a breadth of experience at different divisions inside the company and understand well Deere's culture (and could not, perhaps, work as well outside that culture).
Pay at Deere is broken into salary, discretionary bonus, short-term incentives, mid-term incentives, long-term incentives and other. The board employs a compensation consultant, which tends to ratchet up pay because they look at peers who are doing the same peer reviews and, therefore, also ratcheting up their pay.
Deere's short-term incentive is based on operating return on operating assets for the operating side of the business and return on equity for the finance arm. The operating return metric is adjusted for low, medium and high volume years (which aren't really in management's control). This is a very good incentive program and one of the best I've seen.
The mid-term incentive is based on shareholder value added (operating profit minus cost of capital: 12% for equipment operations and 15% for finance). The metric is judged over rolling 3 year periods. Once again, an impressive incentive system that's fair to shareholders and management.
The long-term incentive consists of performance stock units, restricted stock units, and stock options. The performance stock units are awarded 50% based on revenue growth and 50% on shareholder return relative to the S&P 500 industrial sector. Once again, a very shareholder-friendly reward system.
Other pay is another $153,000 to $520,000 a year, including: personal use of company aircraft, financial planning, relocation, medical exams, perquisites, tax gross ups, and defined contribution plans. That's a bit steep, but not unusual for a company this size.
Deere shows the typical monster payouts that executives would receive upon death, disability, retirement, termination with or without cause, and voluntary separation. It's not my favorite, but what can you do. All the other kids have one, too.
The CEO/chairman averaged $19 million in pay over the last 3 years, and the other 4 executives averaged $4.3 to $4.8 million. Just on a rough comparison with Caterpillar and AGCO in terms of pay relative to revenue and operating profit, Deere falls in between the two, which can be explained simply in terms of company scale (the size of pay relative to the size of sales and profits tends to go down, proportionately as companies get bigger).
Ownership at Deere is not exemplary. The CEO owns $8.1 million in shares (I'm not counting the options they give out as lottery tickets), which is one-half his salary each year. Other executives own similarly paltry amounts with pay anywhere from 1.7 to 12.5 times ownership. This management team's ownership clearly makes them act as hired hands and not owners.
Pay is high, but the incentive to perform along the right dimensions is there. The record of competitive position and economics covered in my last two blog entries is, without doubt, a more important exhibit in judging management.
Evaluation
My overly-detailed analysis above just sets the context for evaluating Deere's managers. What's most important is that management understands the economics of Deere's business and can maintain and expand its competitive advantages over time. Judging by their record over the past 20 years, I'd say they have been doing a good job improving margins, boosting capital efficiency, and making their products the best on the market. They've had a nice tailwind due to ethanol subsidies and global growth, but they've also played that hand well.
The management team has been at Deere a long time. They have ridden through previous boom and bust cycles and should understand how to ride them out. As Martha Stewart would say, that's a good thing.
I'd prefer to see a board with more owners and proven capital allocators. I'd prefer management owned more shares that they purchased with their own money, too. But, Deere also has a compensation scheme that rewards improvements in operating returns to assets and return on equity, awards bonus pay based on operating profits after a meaningful capital charge, and provides performance shares based on revenue growth and total return to shareholders relative to a relevant benchmark.
Deere's board and management may not represent perfect alignment with shareholders, but management is experienced and they are compensated for meaningful performance. They've also demonstrated a track record of improving the economics of the business.
Before I get into Deere's valuation, I need to cover the risks and opportunities that Deere is facing. I'll provide that in two weeks.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
After covering John Deere's (DE) general situation, competitive position, and economics, I will now take a hard look at management. Specifically, I want to examine the board of directors, executive team, and then evaluate both.
Board of Directors
Deere's board consists of 11 members, which I think it too big. It consists of the CEO/chairman, an insider, 5 major executives (from Lockheed Martin, DuPont, Rockwell Collins, BMW, Cargill), 2 minor executives (Springs Company, New Vernon Capital), one professor, and one former general.
I like to see representation by executives who have real experience allocating capital, managing people and making hard decisions. Many of Deere's board members serve on several other boards, though, so I wonder how focused they are on Deere. Professors are very intelligent people with unique knowledge, but that doesn't qualify them to judge a business, capital allocation, or senior executives (any more than being an investor qualifies me to write treatises on economics). The same can be said for a retired general (as an ex-Air Force officer, that's not blind prejudice).
The average pay for the board of directors (not including chair/CEO) is $230,000 per year. That is not a large sum given the size and prominence of Deere.
Directors own anywhere from $299,000 in Deere shares to $2.66 million. 7 members own more share value than 3 years worth of board salary, which I think makes them act more like owners. The other four own 1-3 times board salary, which makes them more inclined to vote their salary than their ownership. Unfortunately, board ownership is almost exclusively from restricted stock awards. In other words, the board hasn't invested their own hard-earned money in Deere like investors.
Deere's board resembles most large company boards, with lots of prominent members--some with business experience, some not--handsomely paid and with little ownership. I'd prefer members who've put their own dollars on the line like investors, and perhaps a couple of directors who are from the asset management world (private equity, money management, etc.). Instead, Deere's board is filled with executives who are likely to feel sympathy with Deere's management where I'd prefer some people willing to hold management accountable to tough standards.
Executive Team
The top five members of Deere's executive team average 28 years at Deere. The CEO has been there 39 years and the CFO is the newbie at 18. I prefer management teams that are brought up in the business, especially a cyclical business like Deere's. Each manager has a breadth of experience at different divisions inside the company and understand well Deere's culture (and could not, perhaps, work as well outside that culture).
Pay at Deere is broken into salary, discretionary bonus, short-term incentives, mid-term incentives, long-term incentives and other. The board employs a compensation consultant, which tends to ratchet up pay because they look at peers who are doing the same peer reviews and, therefore, also ratcheting up their pay.
Deere's short-term incentive is based on operating return on operating assets for the operating side of the business and return on equity for the finance arm. The operating return metric is adjusted for low, medium and high volume years (which aren't really in management's control). This is a very good incentive program and one of the best I've seen.
The mid-term incentive is based on shareholder value added (operating profit minus cost of capital: 12% for equipment operations and 15% for finance). The metric is judged over rolling 3 year periods. Once again, an impressive incentive system that's fair to shareholders and management.
The long-term incentive consists of performance stock units, restricted stock units, and stock options. The performance stock units are awarded 50% based on revenue growth and 50% on shareholder return relative to the S&P 500 industrial sector. Once again, a very shareholder-friendly reward system.
Other pay is another $153,000 to $520,000 a year, including: personal use of company aircraft, financial planning, relocation, medical exams, perquisites, tax gross ups, and defined contribution plans. That's a bit steep, but not unusual for a company this size.
Deere shows the typical monster payouts that executives would receive upon death, disability, retirement, termination with or without cause, and voluntary separation. It's not my favorite, but what can you do. All the other kids have one, too.
The CEO/chairman averaged $19 million in pay over the last 3 years, and the other 4 executives averaged $4.3 to $4.8 million. Just on a rough comparison with Caterpillar and AGCO in terms of pay relative to revenue and operating profit, Deere falls in between the two, which can be explained simply in terms of company scale (the size of pay relative to the size of sales and profits tends to go down, proportionately as companies get bigger).
Ownership at Deere is not exemplary. The CEO owns $8.1 million in shares (I'm not counting the options they give out as lottery tickets), which is one-half his salary each year. Other executives own similarly paltry amounts with pay anywhere from 1.7 to 12.5 times ownership. This management team's ownership clearly makes them act as hired hands and not owners.
Pay is high, but the incentive to perform along the right dimensions is there. The record of competitive position and economics covered in my last two blog entries is, without doubt, a more important exhibit in judging management.
Evaluation
My overly-detailed analysis above just sets the context for evaluating Deere's managers. What's most important is that management understands the economics of Deere's business and can maintain and expand its competitive advantages over time. Judging by their record over the past 20 years, I'd say they have been doing a good job improving margins, boosting capital efficiency, and making their products the best on the market. They've had a nice tailwind due to ethanol subsidies and global growth, but they've also played that hand well.
The management team has been at Deere a long time. They have ridden through previous boom and bust cycles and should understand how to ride them out. As Martha Stewart would say, that's a good thing.
I'd prefer to see a board with more owners and proven capital allocators. I'd prefer management owned more shares that they purchased with their own money, too. But, Deere also has a compensation scheme that rewards improvements in operating returns to assets and return on equity, awards bonus pay based on operating profits after a meaningful capital charge, and provides performance shares based on revenue growth and total return to shareholders relative to a relevant benchmark.
Deere's board and management may not represent perfect alignment with shareholders, but management is experienced and they are compensated for meaningful performance. They've also demonstrated a track record of improving the economics of the business.
Before I get into Deere's valuation, I need to cover the risks and opportunities that Deere is facing. I'll provide that in two weeks.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, October 03, 2014
John Deere's economics
- John Deere has exhibited good, but not great, operating and net margins over the last 20 years relative to the average industrial company
- Deere has, however, produced above average returns on capital employed (that edge looked much better over the last 10 years than the 10 years prior)
- The qualitative nature of Deere's industry and Deere's strong competitive position make those above average returns seem sustainable over time
John Deere stacks up well against its competition, but are its economics compelling?
A good long term investment has strong and sustainable economics. That is to say, it generates above average returns on capital invested and can maintain those returns far into the future. How does Deere look?
One measure of good economics is superior profit margins. That isn't a necessary or sufficient condition, but a business that generates high margins shows it can add a lot of value (the difference between what customers will pay and the costs of production).
Below, I compare Deere to the Value Line Industrial Composite.
- Operating Margins (after cost of goods sold and sales, general & administrative, but before depreciation)
- Deere
- 2009-2013 (last 5 years): 13.5%
- 2004-2013 (last 10 years): 12.5%
- 1994-2013 (last 20 years): 12.4%
- 1994-2003 (10 years prior to last 10 years): 10.2%
- Value Line Industrial Composite
- 2009-2013: 16.4%
- 2004-2013: 16.6%
- 1994-2013: 16.6%
- 1994-2003: 16.2%
(The reason why I look at prior 10 years is because Deere has had an unusually strong tailwind with ethanol mandates and strong global growth over the last 10 years. Because those beneficial conditions may not last, I thought it was prudent to consider Deere's economics in the 10 years prior to that last 10 good years.)
- Net Margins
- Deere
- 2009-2013: 8.2%
- 2004-2013: 7.7%
- 1994-2013: 7.7%
- 1994-2003: 6.4%
- Value Line Industrial Composite
- 2009-2013: 7.4%
- 2004-2013: 7.6%
- 1994-2013: 6.8%
- 1994-2003: 6.2%
Margins, by themselves, are an incomplete picture. More important to investors is return on invested capital.
- Return on Assets
- Deere
- 2009-2013: 4.4%
- 2004-2013: 4.6%
- 1994-2013: 4.6%
- 1994-2003: 3.7%
- Value Line Industrial Composite
- 2009-2013: 6.1%
- 2004-2013: 6.5%
- 1994-2013: 5.4%
- 1994-2003: 4.8%
- Return on Net Assets (working capital, long term debt, equity)
- Deere
- 2009-2013: 14.0%
- 2004-2013: 13.8%
- 1994-2013: 11.8%
- 1994-2003: 8.7%
- Value Line Industrial Composite
- 2009-2013: 8.2%
- 2004-2013: 8.7%
- 1994-2013: 8.5%
- 1994-2003: 8.1%
Deere's return on net assets (a measure I look at because it includes the returns on working capital in addition to debt and equity capital) are superior. I think part of this can be explained by Deere's finance arm, but also by Deere's capital efficiency when it comes to managing working capital. Deere's business looks quite strong by this measure, but you can see that in the period from 20 to 10 years ago, this edge was much smaller.
- Return on Capital (long term debt, equity)
- Deere
- 2009-2013: 20.0%
- 2004-2013: 18.6%
- 1994-2013: 17.6%
- 1994-2003: 13.5%
- Value Line Industrial Composite
- 2009-2013: 10.1%
- 2004-2013: 10.5%
- 1994-2013: 10.4%
- 1994-2003: 10.0%
Deere's return on capital also looks superior. In my opinion, this shows that Deere's business may not run on high margins, but produces a lot of value relative to the capital employed. Notice, too, that Deere's superiority is lower from 20 to 10 years ago, but still significantly above average.
- Return on Equity
- Deere
- 2009-2013: 31.5%
- 2004-2013: 26.0%
- 1994-2013: 22.3%
- 1994-2003: 18.5%
- Value Line Industrial Composite
- 2009-2013: 16.1%
- 2004-2013: 16.4%
- 1994-2013: 16.3%
- 1994-2003: 16.3%
Deere's return on equity is quite enticing. This is due to a combination of superior economics, I think, as well as a good balance of debt and equity capital deployed (particularly the finance arm). This margin of superiority diminishes when looking at 20 to 10 years ago, but does not disappear.
In addition to the quantitative data above, it's important to consider the qualitative side. Deere's business is a cyclical one, but a business that is unlikely to go away. I cannot conceive of a technology that could replace the physical nature of tractors and combines, and that qualitative nature makes for a high degree of sustainability.
Deere's competitive position gives it an edge, too, as I described in last week's blog. Deere can stay ahead of its competition as long as management doesn't squander its lead. In next week's blog, I plan to tackle the subject of Deere's management: how likely are they to maintain Deere's competitive position and maximize its value over time?
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, September 26, 2014
John Deere versus the competition
(Full disclosure: my clients and I own shares of Deere)
Last week, I wrote about some of the issues surrounding the agricultural sector, and raised the question of whether John Deere (DE) might be a good, but lumpy, investment. This week, I put some meat on the bones of my last post with a competitive analysis comparing John Deere to its next two largest competitors: CNH Industrial (CNHI) and AGCO (AGCO).
Revenues
John Deere's revenues are quite a bit bigger than it's two biggest rivals ($ in millions).
Deere: 2013 $34,998, 2012 $33,501
CNHI: 2013 $21,128, 2012 $22,157
AGCO: 2013 $10,787, 2012 $9,962
As you can see, Deere is 1.6x the size of CNHI and 3.3x the size of AGCO in revenues. Granted, these numbers are revenues and not units, and Deere tends to sell larger, more expensive tractors and combines than it's competitors, so the revenue numbers may point more to product mix than unit dominance. In terms of value sold, or market share, though, Deere is clearly far in the lead.
Regional Revenues (note: CNHI includes Mexico in it's North American segment, AGCO and Deere include Mexico in their Latin America segments)
North America (includes Mexico for CNHI, not for AGCO and Deere)
Deere: 2013 $21,821, 2012 $20,807
CNHI: 2013 $5,618, 2012 $5,429
AGCO: 2013 $2,758, 2012 $2,584
Deere is 3.9x CNHI and 8x AGCO in North America. Deere dominates in large, high power tractors by a large margin in this all-important market.
Latin America (includes Mexico for Deere and AGCO, but not for CNHI)
Deere: 2013 $4,287, 2012 $3,589
CNHI: 2013 $1,968, 2012 $1,507
AGCO: 2013 $2,040, 2012 $1,856
Deere is 2.3x CNHI and 2x AGCO in Latin America. Deere isn't as dominant in Latin America as they are in North America, but they are still dominant.
Europe, Middle East, Africa (EMEA), Asia, Asia-Pacific
Deere: 2013 $8,890, 2012 $9,105
CNHI: 2013 $5,037, 2012 $5,252
AGCO: 2013 $5,989, 2012 $5,522
Deere is 1.7x CNHI and 1.6x AGCO in EMEA/Asia/Asia-Pacific. Deere has even less dominance here than in Latin America, but they still dominate nonetheless. This makes sense considering the greater use of smaller, lower horsepower tractors and combines in these markets (because Deere skews to larger, high horsepower equipment).
Operating Profit
Here, too, Deere is just plain bigger.
Deere: 2013 $5,425, 2012 $4,724
CNHI: 2013 $2,002, 2012 $2,145
AGCO: 2013 $1,510, 2012 $946
Deere is 2.5x CNHI and 4.3x AGCO in profit share. Those dollars don't just make the company richer, it makes Deere capable of plowing much more back into improving efficiency and innovating new products.
Research and Development
Deere's higher profits allow it to put more money into engineering newer and better equipment.
Deere: 2013 $1,477, 2012 $1,434
CNHI: 2013 $710, 2012 $718
AGCO: 2013 $353, 2012 $317
Deere outspends CNHI 2x and AGCO 4.4x. Those larger research and development dollars give Deere an edge in maintaining its technological and manufacturing lead.
Capital Expenditure (capex)
Deere spends more on new capital than it's competitors.
Deere: 2013 $1,155, 2012 $1,315
CNHI: 2013 $1,035, 2012 $1,046
AGCO: 2013 $391, 2012 $341
Deere is out-spending 1.2x CNHI and 3.4x AGCO in capital expenditures. More importantly, Deere is generating higher returns on its capex than CNHI or AGCO (as measured by examining incremental growth in net income versus incremental spend on capex over three year periods).
These numbers aren't an exhaustive proof, but they do give you an idea of why Deere might be able to continue dominating the farm equipment market. My comments should not be meant to imply that AGCO and CNHI are slouches, it's just that Deere has done that much better (in fact, AGCO has been doing an excellent job of coming from behind over the last 10 years whereas CNHI has tended to just keep pace).
I think Deere's dominating scale gives it a sustainable competitive advantage over rivals, assuming management doesn't squander that lead (an issue I will address in a later article). But, this doesn't mean the economics of the business are necessarily good. Next week, I'll tackle this topic to see if the economics of the industry and Deere specifically are good enough to want to own.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Last week, I wrote about some of the issues surrounding the agricultural sector, and raised the question of whether John Deere (DE) might be a good, but lumpy, investment. This week, I put some meat on the bones of my last post with a competitive analysis comparing John Deere to its next two largest competitors: CNH Industrial (CNHI) and AGCO (AGCO).
Revenues
John Deere's revenues are quite a bit bigger than it's two biggest rivals ($ in millions).
Deere: 2013 $34,998, 2012 $33,501
CNHI: 2013 $21,128, 2012 $22,157
AGCO: 2013 $10,787, 2012 $9,962
As you can see, Deere is 1.6x the size of CNHI and 3.3x the size of AGCO in revenues. Granted, these numbers are revenues and not units, and Deere tends to sell larger, more expensive tractors and combines than it's competitors, so the revenue numbers may point more to product mix than unit dominance. In terms of value sold, or market share, though, Deere is clearly far in the lead.
Regional Revenues (note: CNHI includes Mexico in it's North American segment, AGCO and Deere include Mexico in their Latin America segments)
North America (includes Mexico for CNHI, not for AGCO and Deere)
Deere: 2013 $21,821, 2012 $20,807
CNHI: 2013 $5,618, 2012 $5,429
AGCO: 2013 $2,758, 2012 $2,584
Deere is 3.9x CNHI and 8x AGCO in North America. Deere dominates in large, high power tractors by a large margin in this all-important market.
Latin America (includes Mexico for Deere and AGCO, but not for CNHI)
Deere: 2013 $4,287, 2012 $3,589
CNHI: 2013 $1,968, 2012 $1,507
AGCO: 2013 $2,040, 2012 $1,856
Deere is 2.3x CNHI and 2x AGCO in Latin America. Deere isn't as dominant in Latin America as they are in North America, but they are still dominant.
Europe, Middle East, Africa (EMEA), Asia, Asia-Pacific
Deere: 2013 $8,890, 2012 $9,105
CNHI: 2013 $5,037, 2012 $5,252
AGCO: 2013 $5,989, 2012 $5,522
Deere is 1.7x CNHI and 1.6x AGCO in EMEA/Asia/Asia-Pacific. Deere has even less dominance here than in Latin America, but they still dominate nonetheless. This makes sense considering the greater use of smaller, lower horsepower tractors and combines in these markets (because Deere skews to larger, high horsepower equipment).
Operating Profit
Here, too, Deere is just plain bigger.
Deere: 2013 $5,425, 2012 $4,724
CNHI: 2013 $2,002, 2012 $2,145
AGCO: 2013 $1,510, 2012 $946
Deere is 2.5x CNHI and 4.3x AGCO in profit share. Those dollars don't just make the company richer, it makes Deere capable of plowing much more back into improving efficiency and innovating new products.
Research and Development
Deere's higher profits allow it to put more money into engineering newer and better equipment.
Deere: 2013 $1,477, 2012 $1,434
CNHI: 2013 $710, 2012 $718
AGCO: 2013 $353, 2012 $317
Deere outspends CNHI 2x and AGCO 4.4x. Those larger research and development dollars give Deere an edge in maintaining its technological and manufacturing lead.
Capital Expenditure (capex)
Deere spends more on new capital than it's competitors.
Deere: 2013 $1,155, 2012 $1,315
CNHI: 2013 $1,035, 2012 $1,046
AGCO: 2013 $391, 2012 $341
Deere is out-spending 1.2x CNHI and 3.4x AGCO in capital expenditures. More importantly, Deere is generating higher returns on its capex than CNHI or AGCO (as measured by examining incremental growth in net income versus incremental spend on capex over three year periods).
These numbers aren't an exhaustive proof, but they do give you an idea of why Deere might be able to continue dominating the farm equipment market. My comments should not be meant to imply that AGCO and CNHI are slouches, it's just that Deere has done that much better (in fact, AGCO has been doing an excellent job of coming from behind over the last 10 years whereas CNHI has tended to just keep pace).
I think Deere's dominating scale gives it a sustainable competitive advantage over rivals, assuming management doesn't squander that lead (an issue I will address in a later article). But, this doesn't mean the economics of the business are necessarily good. Next week, I'll tackle this topic to see if the economics of the industry and Deere specifically are good enough to want to own.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, September 19, 2014
John Deere: down on the farm
(Full disclosure: my clients and I own shares of Deere).
This has been a tough year for the agriculture sector. After a couple of fat years of high profitability, farmers and those who sell to farmers are worried about a couple of lean years. The agriculture sector is a victim of it's own success. High productivity has led to bumper crops that are driving down the prices of corn, soybeans, wheat, etc., and that is leading to lower profits for farmers and lower demand for farm equipment.
That has led to speculation about how long the farm sector will be down. I'll kill the suspense: no one knows.
On the one hand, you have huge supply, both from farmers in the U.S. and around the world (Brazil, in particular, has become very productive). Lots of supply drives down prices. This supply has been "enhanced" by government support of ethanol production and loans for farmers to buy equipment, which means the oversupply may last.
On the other hand, you have demand. Global demand has subsided with slow developed economies in the U.S., Europe and Japan, as well as slower developing and emerging economies in the rest of the world. This is likely to be a temporary phenomenon, but it could last, especially with bad economic policies or geopolitical issues.
So, no one really knows how long this downturn might last. Higher demand caused by accelerating economic growth could make the downturn very brief. Lower supply is the rational economic outcome from low crop prices. How these factors play against each other is simply unknown and unknowable.
But, that is what makes the farm sector such an interesting place to look for value investments.
The economics of the business are good, especially for equipment manufacturers. There are three big producers of farm equipment that share more than 50% of the global market, and that share is likely to grow over time. Those manufacturers are John Deere (DE), Case New Holland International (CNHI) and AGCO (AGCO).
John Deere has the largest share of revenue and profits, and they have wisely plowed those profits back into making better equipment. That gives Deere a sustainable competitive advantage they can maintain as long as they are well managed. Deere dominates the high end of the market for tractors and combines, which is the direction global markets are going as farming becomes more productive and mechanized over time.
That, however, does not remove the cyclical nature of the business. Farm cycles go boom and bust due to government interference, lending practices, weather, global demand, and a host of other issues. This cyclical nature isn't necessarily a bad thing. As Warren Buffett says, I'd rather have a lumpy 15% than a stable 12%.
So, is John Deere a good investment capable of providing a good, but lumpy return? That is the topic I'll pick up again next week.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
This has been a tough year for the agriculture sector. After a couple of fat years of high profitability, farmers and those who sell to farmers are worried about a couple of lean years. The agriculture sector is a victim of it's own success. High productivity has led to bumper crops that are driving down the prices of corn, soybeans, wheat, etc., and that is leading to lower profits for farmers and lower demand for farm equipment.
That has led to speculation about how long the farm sector will be down. I'll kill the suspense: no one knows.
On the one hand, you have huge supply, both from farmers in the U.S. and around the world (Brazil, in particular, has become very productive). Lots of supply drives down prices. This supply has been "enhanced" by government support of ethanol production and loans for farmers to buy equipment, which means the oversupply may last.
On the other hand, you have demand. Global demand has subsided with slow developed economies in the U.S., Europe and Japan, as well as slower developing and emerging economies in the rest of the world. This is likely to be a temporary phenomenon, but it could last, especially with bad economic policies or geopolitical issues.
So, no one really knows how long this downturn might last. Higher demand caused by accelerating economic growth could make the downturn very brief. Lower supply is the rational economic outcome from low crop prices. How these factors play against each other is simply unknown and unknowable.
But, that is what makes the farm sector such an interesting place to look for value investments.
The economics of the business are good, especially for equipment manufacturers. There are three big producers of farm equipment that share more than 50% of the global market, and that share is likely to grow over time. Those manufacturers are John Deere (DE), Case New Holland International (CNHI) and AGCO (AGCO).
John Deere has the largest share of revenue and profits, and they have wisely plowed those profits back into making better equipment. That gives Deere a sustainable competitive advantage they can maintain as long as they are well managed. Deere dominates the high end of the market for tractors and combines, which is the direction global markets are going as farming becomes more productive and mechanized over time.
That, however, does not remove the cyclical nature of the business. Farm cycles go boom and bust due to government interference, lending practices, weather, global demand, and a host of other issues. This cyclical nature isn't necessarily a bad thing. As Warren Buffett says, I'd rather have a lumpy 15% than a stable 12%.
So, is John Deere a good investment capable of providing a good, but lumpy return? That is the topic I'll pick up again next week.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, September 12, 2014
Perhaps a Roth IRA isn't so safe after all
If you could perfectly predict the future, financial planning would be a piece of cake.
Unfortunately, that's not possible. Future rates of return and inflation are not precisely predictable. Neither is how long you will live. Neither are tax rates.
Which brings me to the topic for today. The Roth IRA is a great deal because it allows you to save and invest after-tax dollars that won't be taxed on withdrawal. Even better, unlike a traditional IRA or 401(k) plan, retirees aren't mandated to pull certain amounts out each year, providing flexibility in income and tax planning. Better still, you can pass those dollars on to heirs with much fewer restrictions than is the case with a traditional IRA or 401(k).
That is, unless they change the rules.
Well, apparently, changing the rules is precisely what is being considered. According to an article in the WSJ, two proposals being sent to Congress are trying to do just that.
First, one proposal seeks to require Roth owners to start taking distributions at age 70 1/2, just like with traditional IRAs and 401(k)s. That would remove a major element of the Roth's appeal both for retirees and their heirs.
Second, the other proposal attempts to end the ability of heirs to stretch out distributions. This would eliminate another of the major appeals of the Roth IRA as an estate planning tool.
The Roth IRA has created a garden industry of advisers, lawyers and accountants who have helped investors (for an hourly fee, of course), to shuffle assets from traditional IRAs to Roths and back again in order to dodge the tax man. This has always been premised on the predictability of the law, which is now in question.
And, this brings us back to the difficulty of financial planning. It isn't easy, nor is it rocket science. What makes financial planning difficult is that it is inherently decision making under uncertainty. If you say X will result if Y occurs, there is usually an assumption behind that. When that assumption can and almost certainly will change--like tax laws--you can wind up with plans that aren't quite as solid as they were described to be.
I frequently council investors against setting their financial plans in too much concrete. Instead, a range of assumptions for returns, inflation, taxes, etc. should be used. Nor should it be assumed that things like Social Security will be around, especially for younger investors; at any point in time, the majority or vocal minority can yank away the benefits you were promised.
Instead, it's best to plan to take care of yourself regardless of how the rules are changed. It's better to be approximately right than precisely wrong.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Unfortunately, that's not possible. Future rates of return and inflation are not precisely predictable. Neither is how long you will live. Neither are tax rates.
Which brings me to the topic for today. The Roth IRA is a great deal because it allows you to save and invest after-tax dollars that won't be taxed on withdrawal. Even better, unlike a traditional IRA or 401(k) plan, retirees aren't mandated to pull certain amounts out each year, providing flexibility in income and tax planning. Better still, you can pass those dollars on to heirs with much fewer restrictions than is the case with a traditional IRA or 401(k).
That is, unless they change the rules.
Well, apparently, changing the rules is precisely what is being considered. According to an article in the WSJ, two proposals being sent to Congress are trying to do just that.
First, one proposal seeks to require Roth owners to start taking distributions at age 70 1/2, just like with traditional IRAs and 401(k)s. That would remove a major element of the Roth's appeal both for retirees and their heirs.
Second, the other proposal attempts to end the ability of heirs to stretch out distributions. This would eliminate another of the major appeals of the Roth IRA as an estate planning tool.
The Roth IRA has created a garden industry of advisers, lawyers and accountants who have helped investors (for an hourly fee, of course), to shuffle assets from traditional IRAs to Roths and back again in order to dodge the tax man. This has always been premised on the predictability of the law, which is now in question.
And, this brings us back to the difficulty of financial planning. It isn't easy, nor is it rocket science. What makes financial planning difficult is that it is inherently decision making under uncertainty. If you say X will result if Y occurs, there is usually an assumption behind that. When that assumption can and almost certainly will change--like tax laws--you can wind up with plans that aren't quite as solid as they were described to be.
I frequently council investors against setting their financial plans in too much concrete. Instead, a range of assumptions for returns, inflation, taxes, etc. should be used. Nor should it be assumed that things like Social Security will be around, especially for younger investors; at any point in time, the majority or vocal minority can yank away the benefits you were promised.
Instead, it's best to plan to take care of yourself regardless of how the rules are changed. It's better to be approximately right than precisely wrong.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Friday, September 05, 2014
China: how will its mass urbanization impact the global economy
China's impact on the global economy is hard to overstate.
Not only is it the world's second largest economy (by country, not region), but also the source of a huge amount of incremental growth over the last 15 years.
I've seen estimates that over 50% of the demand for iron ore and copper comes from China. Almost 50% of worldwide steel is produced in China. I once read that China has used as much concrete in 2011 and 2012 as the U.S. used in the 20th century! I don't know if such estimates are specifically accurate, but their magnitude gives you a flavor of how China has impacted the global economy. In short, the economic crisis since 2008 would have looked a lot worse without China.
Given that, it's important to consider the impact of China on future economic growth.
One of the dynamics going on in China is the move from a more production-based to a consumption-based economy. China is approximately 34% consumer-based versus 70% in the U.S. China has built an economy, predominantly from the top down, that has mostly produced goods for other countries, like the U.S., Europe and Japan. But that source of growth was limited. You can only take market share for so long before you need to become your own source of growth.
China is trying to make that transition, but getting a command and control economy to do that without large disruptions is very difficult.
One aspect of such a transition is having hundreds of millions of Chinese farmers move from the hinterland to cities. In cities, they can work in factories and produce much more than they can on the farm. That higher productivity leads to higher consumption, thus achieving China's goals.
But, how do you move hundreds of millions of people from farm to city. In the west, and Japan, that transition took place over many decades, and mostly organically (by organically, I mean through free market forces, not through government fiat). Those transitions led to disruptions, just as it will in China.
China, however, is trying to do this much more quickly and on a much more massive scale. China wants to move around 235 million people to cities over the next 20 years. For perspective, that's the size of the 10 largest cities in the world now (from Tokyo at 37 million to Mexico City at 20 million). Can you even imagine trying to regrow 10 of the largest cities in the world, over the next 20 years? (for more information, read Stratfor's article on the subject)
Achieving such a task is Herculean, and it will impact the global economy.
How? I don't know. It could all happen smoothly, which I consider unlikely. It could occur with either international or domestic war, as such pressures have created throughout history. It could happen in fits and starts with massive swings in economic growth from boom to bust. No one knows, really, but it bears watching.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Not only is it the world's second largest economy (by country, not region), but also the source of a huge amount of incremental growth over the last 15 years.
I've seen estimates that over 50% of the demand for iron ore and copper comes from China. Almost 50% of worldwide steel is produced in China. I once read that China has used as much concrete in 2011 and 2012 as the U.S. used in the 20th century! I don't know if such estimates are specifically accurate, but their magnitude gives you a flavor of how China has impacted the global economy. In short, the economic crisis since 2008 would have looked a lot worse without China.
Given that, it's important to consider the impact of China on future economic growth.
One of the dynamics going on in China is the move from a more production-based to a consumption-based economy. China is approximately 34% consumer-based versus 70% in the U.S. China has built an economy, predominantly from the top down, that has mostly produced goods for other countries, like the U.S., Europe and Japan. But that source of growth was limited. You can only take market share for so long before you need to become your own source of growth.
China is trying to make that transition, but getting a command and control economy to do that without large disruptions is very difficult.
One aspect of such a transition is having hundreds of millions of Chinese farmers move from the hinterland to cities. In cities, they can work in factories and produce much more than they can on the farm. That higher productivity leads to higher consumption, thus achieving China's goals.
But, how do you move hundreds of millions of people from farm to city. In the west, and Japan, that transition took place over many decades, and mostly organically (by organically, I mean through free market forces, not through government fiat). Those transitions led to disruptions, just as it will in China.
China, however, is trying to do this much more quickly and on a much more massive scale. China wants to move around 235 million people to cities over the next 20 years. For perspective, that's the size of the 10 largest cities in the world now (from Tokyo at 37 million to Mexico City at 20 million). Can you even imagine trying to regrow 10 of the largest cities in the world, over the next 20 years? (for more information, read Stratfor's article on the subject)
Achieving such a task is Herculean, and it will impact the global economy.
How? I don't know. It could all happen smoothly, which I consider unlikely. It could occur with either international or domestic war, as such pressures have created throughout history. It could happen in fits and starts with massive swings in economic growth from boom to bust. No one knows, really, but it bears watching.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
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