Tag Archives: stock prices

Buying High and Selling Low

Stock buybacks have occurred at a faster pace this year than last year. According to the Wall Street Journal, “Companies in the S&P 500 increased share repurchases by 29% during the three months through January 2014 compared with a year earlier”. During a stock buyback, a company purchases outstanding shares at current market prices and pays stockholders cash for their shares. The repurchased shares are placed in the company’s treasury stock, which means they are no longer considered outstanding shares. According to the Wall Street Journal, “In theory, buybacks are nearly equivalent to dividends as a way to return cash to shareholders”. Both cash dividends and stock buybacks provide investors with a cash payment based upon the number of shares they own. Cash dividends, which are decided upon by the company, are usually a small fraction of share price. On the contrary, stock buybacks occur at market prices that are determined my market forces. Although investors prefer stock buybacks when stock prices are high, corporations should prefer repurchasing their own stock when it is cheap. However, companies are performing stock buybacks while stock prices are very high – this rewards investors while the company takes unnecessary risk.

Besides returning cash to shareholders, companies have other incentives to conduct stock buybacks. With less shares outstanding, stock buybacks artificially increase earnings per share (EPS). According to the Wall Street Journal, “By reducing shares outstanding, repurchases flatter earnings per share, making stocks look more attractive. During the reporting season that just ended, earnings growth slowed to a crawl and likely would have been negative without buybacks”. A company’s business model should prioritize producing goods and services. A successful business model will exhibit continuous growth in earnings. When organic growth slows, however, companies can propel stock valuations through stock buybacks. Although buybacks can inflate EPS and push up a company’s stock price, it can be a risky strategy that can cause problems in the future.

Despite the bull market and lofty stock prices, companies have been conducting a record amount of stock buybacks. According to the Wall Street Journal, “Buybacks and bull markets are self-reinforcing”. During a bull market, companies feel pressure to keep increasing EPS (and subsequently increasing stock price) and to put all of their cash to use. Unfortunately, spending too much on stock buybacks benefit the short run while causing damage in the long run. According to the Wall Street Journal, “If share repurchases consume too much of companies’ excess profits, the underlying businesses might end up starved, which could lower future returns”. Although companies might wish to perform buybacks and boost EPS in the short run, it can be a waste of cash that would otherwise be spent to increase EPS in the long run. Companies should be careful in how much money they spend on share repurchases, which are not essential to day-to-day business operations. Corporate spending should prioritize other expenditures before stock buybacks.

Ironically, companies would get more bang for their buck if they conducted buybacks when they feel least comfortable (i.e. during bear markets when stock prices are low). According to the Wall Street Journal,

During the previous bull market, buybacks peaked in the same quarter the stock market did. Less than two years later, during the quarter in which tock prices bottomed, companies spent 83% less on buybacks. That is despite the fact they would have gotten far more earnings-boosting effect at those low prices for each dollar spent.

When done at the right time (i.e. when stock prices are low), stock buybacks can be more effective and less risky. In order to time buybacks right, management must be patient and not give into short term temptations. Although it can be tough (or even impossible) to determine the exact value of a stock, companies should be able to tell if their stock price is roughly overvalued or undervalued. Even when stock prices are low and stock buybacks would make  sense, the economic climate and outlook might be more negative causing companies to make conservative decisions. Stock buybacks might be hard to time, but I think it is pretty clear that companies should avoid buying high and selling low.

Financial Markets: Expensive Relative to Earnings?

The bull market in the United States is old news. Stocks rose again today. According to the Wall Street Journal, “The Dow Jones Industrial Average rose 181.55 points, or 1.1%, to 16247.22, its biggest daily gain in two weeks“. The question is how long the bull market will continue.

An important determinant for the duration of the bull market (i.e. rising stock prices) is corporate profits. According to the Wall Street Journal, “Some of the tectonic plates under the market also are shifting. Bit by bit, stocks have become more expensive compared with the profits of the corporations that issue them. High stock prices make would-be buyers wary, just like high prices for anything. At these prices, the goods, in the form of corporate sales and profits, have to be very high quality”. The notion of this statement is that high prices should be justified with high corporate profits. If high prices cannot be justified with high profits today, then high prices must be justified by high profits tomorrow. For example, Amazon trades at a very high price because of high expectations about future profits. According to Burton Malkiel in A Random Walk Down Wall Street, “Hazardous as projections may be, share prices must reflect differences in growth prospects if any sense is to be made of market valuations”. Such growth prospects reflect expectations about the future, which are inherently risky because the future is hard (maybe even impossible) to predict. In order to determine the health of the bull market, we must consider corporate profits both today and tomorrow.

A very common financial metric used to relate different stocks is the price-to-earnings multiple. According to Malkiel, “[Price-earnings (P/E) multiples rather than market prices] provides a good yardstick for comparing stocks – which have different prices and earnings – against one another”. The P/E multiple is calculated by dividing today’s stock price by the most recent earnings-per-share (EPS). Looking at the P/E multiple for two stocks provides useful information about differences in investor sentiment. For example, Amazon trades at an extraordinarily high P/E of 644 because it has a high price relative to its earnings. According to Malkiel, “It is clear that, just as Rule 1 asserts, high P/E ratios are associated with high expected growth rates”. Amazon’s high P/E reflects extremely positive investor sentiment regarding future growth. On the contrary, Apple’s P/E multiple is only 13. Although Apple earns much more than Amazon, investors have much lower expectations about future growth. At one point, Apple had a much higher P/E multiple. Stock prices change rapidly to reflect expectations about the future.

If we consider the P/E of the entire stock market relative to historical averages, then current stock prices seem high. According to the Wall Street Journal, “FactSet, for example, compares stock prices to companies’ earnings from operations for the past 12 months. That figure today is 16.4, up from 14.5 a year ago. That is well above the historical average of 14. Stocks topped out at this level in 2007 but in 2010, they returned to this price-to-earnings level and kept rising”. I believe historical averages have significant merit – especially relative to future projections, which are unreliable. One way to interpret the high P/E multiple of today’s stock market is that it is a result of high expectations for future growth. If today’s high expectations are not met tomorrow, then stock prices would likely fall to reflect lower expectations and P/E multiples.

Despite today’s relatively high P/E multiples, some investors might have reason to believe that stocks can rise indefinitely. According to Malkiel, “Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing”. Technical analysis assumes that stock prices reflect all available information and its followers analyze stock charts in order to interpret trends. If you believe in the castle-in-the-air view of stock pricing, then you might think stock prices can rise forever. According to the Wall Street Journal, “Barring a return to the irrational exuberance of the 1990s, stocks could find it hard to repeat 2013’s exceptional returns, and they could be in for a pullback”. Although financial markets might seem expensive to a fundamentalist (i.e. someone who performs security analysis such as analyzing P/E ratios), they might seem cheap to investors with irrational exuberance (i.e. investors who perform technical analysis).

Random Events in Finance

As I am sure that almost all of you have heard, there was a Malaysian Airlines flight that went missing a few days ago en route to China. The flight carried 239 passengers and crew and still has not been found. Since there are some articles pointing out that fake or stolen passports were used to board the plane by a couple of passengers, obviously there are concerns about those two hijacking the plane or causing it to go down. Whatever the case, this will obviously have an impact on Malaysia Airlines financially (and possibly the airline industry as a whole).

The hard part for those working at Malaysia Airlines is that this isn’t really the company’s fault. This could have happened to any airline and if it turns out that the men who boarded the flight with stolen passports had anything to do with it, it was probably the fault of whatever government agency handles that in Malaysia (I’ve never been out of the country so I’m assuming there’s some kind of TSA equivalent there). Nevertheless, this caused their stock price to fall 4 percent today and may fall more depending on the outcome of the search for the plane. This is the equivalent of 50 million dollars of market value that vanished today alone. This got me thinking that, while there are ways to mitigate risk in investing, these types of events can’t be accounted for.

I was searching for other examples of seemingly random events effecting stock prices and stumbled on another interesting (and much more upbeat) example involving the hit “Gangnam Style” by Korean artist PSY. Interesting fact: PSY’s father is the CEO of a semiconductor company. A couple of years ago when that song was a chart topper, that company (called D I Corps) stock price more than doubled from 1500 won to 3600 won. While this obviously created a lot of value for the company’s investors, PSY’s father held 10 percent of the company at the time. As a bit of an aside, while reading about this, I found out that South Korea’s market regulations don’t allow a stock price to fluctuate by more than 15 percent on any given day, but when the article was written, D I Corp hit that limit for 3 consecutive days.

Anyways, I thought that it was interesting to think about these kind of seemingly random events and their influence on a stock price and noting that, although rare, these events are one example of why risk can never be entirely eliminated.

Since this stuff interests me and I we have to comment on each other’s posts anyways, if any of you can think of any other examples of random events effecting a stock price, feel free to share them below.

Tesla Shifts into High Gear

With stock price surging 16 percent in a day, Tesla wins back the spotlights from all media on Tuesday. Ever since last week when Tesla reported much strong than expected profits and forecast it will sell 55% more vehicles than last year, its stock price has been soaring like crazy. After a Wall Street analyst told investors that Tesla could shake up the electric utility sector as well as the auto industry on the same day Consumer Reports named the Model S its top pick of this year’s cars, the stock price immediately spiked up by $34.65 to close at $252.30 on Tuesday. With the record high stock price, Tesla is a $30 billion company now.tesla

Tesla Motors Inc. might be on the verge of disrupting two industries, warranting a share price of $320, says Morgan Stanley analyst Adam Jonas, in a note to investors released Tuesday. This new share price target is more than doubling the last one that was $153, a number astonishing already. And there still potential of quadrupling this number in the future.

What’s driving all these? The expectations from two trillion-dollar industries: automotive and energy. It’s no news that Tesla is challenging every auto maker on the planet; now the warrior is preparing to take the energy leaders: very soon, Tesla is going to announce plans to build the world’s largest battery factory in the U.S. “We’re talking about something comparable to all lithium ion production in the world, in one factory,” said Elon Musk.

The factory will produce endless supply of lithium-ion battery pack, not only for Tesla vehicles, but also for every home and business. Such low cost energy storage solution will completely rewrite the game rules of its adjacent industries, for example, the electric power industry. Currently the electric companies charges more during peak hours. With Tesla’s battery pack, people will be able to avoid this extra cost. And this is nothing but a tip of the iceberg.

“Might we one day look back at Tesla’s humble beginnings as simply a car maker much as Amazon began as a book seller?” in Morgan Stanley’s report, it asks.

Indeed we might. One has to admit that Elon Musk has a pair of eagle eyes and a Jedi mind. From e-commerce to automotive, clean energy, mass-transportation and space exploration, this flamboyant entrepreneur only sets his foot on the most lucrative industries in the most disruptive way. With a track record of successful delivering on what he promised, Musk might actually create another “Tunguska Explosion” with Tesla.

Suntory’s Acquisition of Beam: Expensive and (Hopefully) Lucrative

On January 13, Suntory Holdings Ltd. announced it would acquire Beam Inc. for $83.50 per share, which is a 25% premium to the January 10 closing price (the 1/10 stock price is the unaffected price before the news of the acquisition was announced and the stock price jumped). The deal, expected to be completed in June, values Beam at 20.5 times EBITDA (earnings before interest, taxes, depreciation, and amortization). Beam’s enterprise value-to-EBTIDA multiple, which is a common financial metric used in valuations, is expensive when considering that median multiple in the industry in the last five years is 12-14 times EBITDA. In addition, it is the fourth highest valuation in the spirits industry in the last decade. To add a little more perspective, this is the largest beverage deal since Inbev acquired the remaining 50% of Modelo SAB for $17.2 billion in 2012. Although Suntory is certainly paying top dollar for Beam, Suntory expects the acquisition will offer them many lucrative growth opportunities.

Suntory produces Yamazaki whiskey and Premium Malt’s Beer, which are household names in Japan. However, Suntory wants exposure overseas where there is high growth compared with slow growth at home due to an aging population. According to the Wall Street Journal, “Suntory Holdings Ltd. tried to cast aside any lingering doubts that its $13.6 billion acquisition of Beam Inc. is overpriced, saying it will successfully capitalize on the overseas brand recognition of the U.S. whiskey maker as it transforms into a global spirits competitor”. In 2011, 80% of Suntory’s revenue came from Japan. Following its acquisition, 60% of Suntory’s revenue is expected to come from the United States. As a result, Suntory’s acquisition of Beam is positioning the firm to be more diversified away from Japan. I believe this is a good decision because it decreases idiosyncratic risk of having most of its revenues be dependent on the health of the Japanese economy.

Beam is also a rare example of a pure play alcohol company, which means it has a single business focus. Suntory, which approached Beam with an unsolicited offer, is demonstrating “strong enthusiasm for forging ahead with its whiskey business”. For Suntory, the scarcity value of a pure play alcohol company might have provided additional incentive to pay a high price. Furthermore, there has been significant growth in spirits within the beverage industry. Suntory’s acquisition of Beam increases its market share in the United States, the world’s biggest spirits market, from 1% to 11%. In the United States, Beam is the second largest whiskey maker behind Jack Daniels. Similar to Jack Daniels, Beam has a very strong brand. According to the Wall Street Journal, “While Suntory’s whiskey products have been gaining aficionados and accolades in the U.S. and Europe, their brand recognition is still much weaker than Beam’s labels… The company therefore hopes the deal will give it strong ammunition in the form of globally recognized brands to embark on an offensive in overseas markets”. The value of a brand is hard to quantify because it is hard to determine what amount of sales or pricing power come from the strength of the brand. Although critics claim Suntory overpaid for Beam, I believe Suntory will benefit from Beam’s strong brand and its exposure in the United States.

Despite the tremendous potential for growth in this acquisition, Suntory will also be taking some calculated risks due to the financing of the deal. Suntory’s acquisition of Beam is an all cash offer, which means Suntory will issue debt. Suntory will need to issue $12 billion in debt and credit agencies have warned that this massive amount might result in a downgrade of Suntory’s debt. Downgrading of debt is never a good thing as it usually increases borrowing costs for the company (lenders demand a higher interest rate to be compensated for the larger perceived risk). However, Suntory should be able to reduce this debt over time and restore its credit rating. If Beam proves to be as profitable as Suntory hopes, then Suntory may be able to pay off this debt sooner than expected. 

Fed States That Tapering Will Continue

Yesterday, the Federal Reserve released their final decision to cut monthly bond purchases again by another $10 billion; this monetary policy is also known as quantitative easing. Under the leadership of Ben Bernanke, and despite concerns that the Fed’s decision is causing problems in emerging markets, the committee voted unanimously for the first time since 2011. The decision reflected the Fed’s optimism that the economy is finally stabilizing for faster growth, citing higher household spending, business profits and investments, as well as declining unemployment rates.

As a result of the Fed’s decision, U.S. stocks fell, creating volatility in the market and reversing any prior gains. For example, the Dow briefly fell over 200 points and Nasdaq declined about 47 points. Some stocks are even on pace for their biggest drop in years. However, this is what people were looking for, to be able to reinvest their money at these lower costs. The question is: Is this a buying opportunity? Or is this an indication that the direction of the market is changing? The New York Times states that this retreat is causing a shift in investment patterns as investors are beginning to anticipate the return of higher interest rates in the U.S. as opposed to chasing higher returns in foreign markets as before.

Since the stock market and interest rates tend to move in opposite directions, interest rates fell as a result of the cut in monthly bond purchases, keeping them even closer yet to zero. As a result, this stimulates the economy by making corporate and consumer borrowing easier and therefore increasing consumer spending throughout the economy. But, at the same time, lower interest rates mean that people who are lending money and buying bonds will have less of an opportunity to collect income from interest. A decrease in interest rates will cause investors to move away from the bond market and businesses will be able to finance expansion, such as being able to purchase more capital, at a cheaper rate. If businesses can increase their potential earnings through greater investments, this could then lead to an increase in stock prices.

However, unless a much larger scale crisis emerges, the Fed will most likely not deviate from its current path. “The clear Fed default position is that tapering will continue”, stated Ian Shepherdson. “It would not even be a surprise to see the Fed’s tapering increase to $15 billion or $20 billion”, says Jennifer Vail.