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The Problem With Accounting Book Value

In our recent article on the flaws in return on equity , we showed how it has no correlation with several different measures of valuation. However, there is one valuation metric, price-to-book (“P/B”), that, at first, appears to correlate strongly with ROE. A more rigorous look reveals the relationship between the two variables is not as strong as it first appears. Major outliers can disproportionately skew correlations, and that’s what happens with a cursory assessment of the ROE versus P/B correlations. Removing those companies (just 3 in this case) that each had at least a 5% impact on the r-squared value, along with the companies that had negative book values, reveals a weak, 27%, correlation. See Figure 1. Figure 1: Correlation Is Not Actually That Significant Click to enlarge Sources: New Constructs, LLC and company filings. When not removing any of the major outliers hat skew the correlations, ROE and P/B can have an extremely high correlation. Figure 2 shows an r-squared value of 98%. Figure 2: Seemingly High Correlation Between ROE and P/B Click to enlarge Sources: New Constructs, LLC and company filings. As Figure 1 shows, changes in ROE actually explain just 27% of the difference in P/B between different companies. Neither metric is a consistently useful valuation indicator. Both are prone to significant deviation from underlying economic reality because they both rely on the same flawed accounting rules. Book Value Can Be Misleading Accounting book value suffers from a few major flaws when it comes to measuring valuation That book value can be written down at management’s discretion at any time. Businesses can hide both assets and liabilities off the balance sheet so that they are not reflected in accounting book value. Accounting rules are designed to give the best estimate of liquidation value for debt investors, not to measure the capital used to generate returns, which is what matters to equity investors. Since shareholder’s equity and accounting book value are the same thing, both ROE and P/B rely on this same accounting construct, making them both equally unhelpful for equity investors. The Threat Of Write-Downs Mergers and acquisitions represent some of the most common sources of artificial book value. When one company buys another company at a premium to its net asset value, the excess purchase price is recorded as goodwill. Goodwill is recorded as part of accounting book value, but often ends up getting written down if the acquisition underperforms expectations. Write-downs end up being very common. 53% of all acquisitions end up destroying value, and we’ve found tens of thousands of write-downs totaling over a trillion dollars in value in the filings we’ve parsed dating back to 1998. Figure 3: Book Value Disappears During Times Of Risk Click to enlarge Sources: New Constructs, LLC and company filings. They end up happening most often during market crashes, as shown in Figure 2. That means investors who thought they were in cheap stocks due to the P/B ratio come in for a nasty surprise when billions of dollars get wiped off the balance sheet. Hidden Assets And Liabilities We make several adjustments to get from reported net assets to invested capital because companies can hide assets and liabilities off of the balance sheet in the form of reserves , operating leases , deferred compensation , and many other techniques. These off-balance sheet arrangements meant that the shareholder’s equity line ignores a significant amount of the resources that a company uses in its operations. Liquidation Value Has Limited Value For Equity Investors Accounting book value is meant to measure the potential assets available to investors in the event of liquidation, and that’s simply not a very useful measurement for most equity investors. If the company you’re investing in gets liquidated, that’s almost always a failed investment. Even the idea that a low price to book limits your potential downside is flawed. Write-downs or hidden liabilities can send the stock price below book value, as can a company earning a negative return on invested capital ( ROIC ). Accounting rules were designed to be used by debt investors. Equity investors should not expect the financial statements generated by these rules to contain the numbers that accurately reflect their concerns. Measure Economic Book Value Instead of focusing on accounting book value, investors should be looking for companies that have a low price to economic book value ( PEBV ). Rather than relying on accounting rules, economic book value comes from after tax operating profit ( NOPAT ) and weighted average cost of capital ( WACC ). Instead of measuring the liquidation value of a company, it measures its zero-growth value, which is a better baseline for equity investors. Rather than looking at the flawed metrics of ROE and P/B, we’ve found that ROIC and PEBV tend to be better indicators of future performance. Recent examples of this phenomenon include: Nvidia (NASDAQ: NVDA ), our long idea on September 24. From an ROE and P/B perspective, NVDA looked like it was middle of the pack in the semiconductor industry. Our research showed that it was actually one of the most profitable and cheapest companies in the industry, with an ROIC above 30% and a PEBV of just 1.1, implying only 10% NOPAT growth for the rest of its corporate life. In the past two and a half months, NVDA is up 37% El Pollo Loco (NASDAQ: LOCO ), our Danger Zone pick from March. Non-operating items inflated GAAP net income, and off-balance sheet debt obscured the true amount of capital used in the company’s operations. This helped LOCO earn an ROE of 20%, much higher than its actual ROIC of just 6%. And while its P/B of 4.8 didn’t look cheap, it was still better than its PEBV of 5.2. LOCO has collapsed in recent months and is now down over 50% since our call. Looking at ROIC and PEBV help you to identify winners and losers because those metrics cut through the noise and artificial accounting constructs that are at the heart of the valuation methodologies used by many investors. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

Courage Required To Ride Out Volatile Markets

By Brian Levitt, Senior Investment Strategist As investors contend with the worst start to a year for the equity markets in recorded history, we focus on one of our favored principles of sound investing: Courage. Winston Churchill once said, “Courage is rightly esteemed to be the first of human qualities because it is the quality which guarantees all others.” Anything in life worth achieving requires consistent courage and fortitude. Investing is no different. Today’s market news and challenges, while daunting and significant, pale in comparison to events of the past such as the Great Depression, two world wars, 9/11, and the 2008 financial crisis. Every generation faces challenges that often appear both unique and overwhelming at the time but when viewed through the sobering lens of history are judged to be neither (Exhibit 1). Markets historically continue their inexorable climb. Why? Because in spite of our challenges and shortcomings, the human race is remarkably resilient and people are masterful inventors and innovators who always strive to create a better place for themselves and society at large. Financial markets have always reflected the improving human condition. Fact: Corrections Happen Often Market corrections happen fairly often, even in good years. 1 From 1981 to 2015 the S&P 500 Index experienced at least a 5% intra-year decline every year but one (1995). The average annual correction over the past 34 years has been 14.4%! In spite of these declines, equities posted positive total returns in 29 of the last 35 years, with an annualized return of more than 11%. As Exhibit 2 illustrates, volatility does not equal loss, unless of course you sell. History shows it doesn’t take very long for market corrections (declines of greater than 10% but less than 20%) to reverse and return to prior peaks. The mean time to market recovery has only been 107 days, 2 or shorter than the National Football League season, which always seems to go by way too fast (Exhibit 3). While true bear markets (declines of greater than 20%) do take longer to recover, it should still be of little consequence to long-term investors. A $10,000 investment made 50 years ago, on January 1, 1966, would be worth over $2.2 million today, even with all the corrections and bear markets of the last half-century. In the words of the Greek philosopher Plato, “Courage is knowing what not to fear.” It remains sound advice for investors, who should have the courage to know not to fear market swings. Compelling wealth management conversations is a program designed to help provide philosophical and historical context and perspective to keep investors “buckled in” and stay the course during uncertain times (and when have times not been uncertain), while providing a framework to help identify the best opportunities going forward. Click to enlarge 1 Source: Bloomberg, 12/31/15. Past performance does not guarantee future results. 2 Source: Ned Davis Research, 12/31/15. Past performance does not guarantee future results. 3 Source: Bloomberg 12/31/15. Past performance does not guarantee future results. Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Carefully consider fund investment objectives, risks, charges, and expenses. Visit oppenheimerfunds.com or call your advisor for a prospectus with this and other fund information. Read it carefully before investing. OppenheimerFunds is not affiliated with Seeking Alpha. ©2016 OppenheimerFunds Distributor, Inc.

ETF Trends For 2016: Part 1, Currency-Hedged Products

2015: A Quick Look Back Constant talk of interest rate hikes, the China market correction in August and the start of ‘chip’ credit cards in the U.S. – these are the things I believe will stand out in my mind if asked 10 years from now what happened in the world of finance in 2015. However, for Exchange Traded Funds (ETFs) 2015 was all about the continuing growth of Smart Beta strategies, the potential for Non-Transparent Exchange Traded Mutual Funds and new niche funds (like the iShares Exponential Technologies ETF (NYSEARCA: XT ) or the Restaurant ETF (NASDAQ: BITE )). According to ETF.com : As of Dec. 3, 2015, 270 ETFs had launched on U.S. exchanges. That is far beyond the roughly 200 funds that rolled out in 2014, and sets 2015 up to be a record-breaking year. You have to go back nearly a decade to find a year that achieved a similar number of launches. Click to enlarge As shown by the above image from the ICI 2015 Investment Company Fact Book , ETFs continue to grow in assets under management (AUM) and the number of fund offerings for investors. However, ETFs have yet to overtake mutual funds. But at current growth rates, ETFs will see parity soon enough. According to an article from Camilla de Villiers of Thomson Reuters: ETF assets today are expanding by 24% per annum – triple the rate of traditional mutual funds. Notwithstanding their popularity, ETFs have fallen well short of displacing the $16 trillion mutual fund industry. But over the long term, on current rates of growth, mutual funds and ETFs will reach parity at $50 trillion each by 2030. Earlier this year, Schwab commissioned an online study to gauge U.S. investor interest in ETFs (pdf download linked here ). The full report is a great read and full of useful data, but one key point especially stood out. As ETF interest continues to grow, we also see that the most avid users are the tech savvy first adaptors, millennials. Click to enlarge As of publication, we can see (using ETF.com’s Fund Flows tool ) investors in 2015 were not just interested in plain vanilla market cap-weighted funds, but their interest in specialized tools to conquer the market has continued to grow. However, old standbys like the Vanguard S&P 500 ETF (NYSEARCA: VOO ), the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG ) and the Vanguard Total Stock Market (NYSEARCA: VTI ) do continue to see investor appreciation. But the continuing impressive growth of ETF assets is to some extent old news in the investing world. What we’d like to focus on in the rest of this brief report are 3 key industry trends and their implications for the continued success of ETFs in the future. In this first part, we are going to cover currency-hedged products, while parts 2 and 3 will be on robo investors and expense ratios respectively. Currency-Hedged Products & Iterations On A Theme WisdomTree (NASDAQ: WETF ) launched its first currency-hedged fund in 2006, the Japan Hedged Equity Fund (NYSEARCA: DXJ ), and it took three-and-a-half years for them to launch a second, the Europe Hedged Equity Fund (NYSEARCA: HEDJ ). Clearly the idea didn’t catch fire right away, but it is growing rapidly now. There are now over 50 ETFs with a mandate to not only invest in equities from a region, but also neutralize exposure to fluctuations between that region’s currency and another (often the U.S. dollar). HEDJ and the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA: DBEF ) even led fund creations for 2015, with $15.77 and $12.67 billion respectively, as concerns around a weakening euro hit investors. This slight change in mandate from your average international-focused index fund can have a dramatic effect on returns. For example, see DXJ and HEDJ’s 5-year returns against two popular non-hedged funds tracking Japan and Europe as well, the iShares MSCI Japan ETF (NYSEARCA: EWJ ) and the Vanguard FTSE Europe ETF (NYSEARCA: VGK ). Click to enlarge To be fair, a currency hedge can be a negative thing for investors as well. When the dollar starts to fall against a foreign currency, currency-hedged investors lose out on the gain from this relationship. As stated by Chris Dieterich of Barron’s : For now, WisdomTree’s stock looks likely to behave as a leveraged play on the dollar. The higher the greenback goes, the more traders will clamor for currency-hedged ETFs. When wondering where the push for these funds came from finally and where they will go from here, we turn to a quote from Greg McFarlane of Investopedia : The upsurge in currency-hedged ETFs is a recent phenomenon spurred by an unmistakable cause – national banking authorities obsessed with inexpensive money. Players are entering the market at an alarming rate. With more such ETFs available to the individual investor, and firms thus forced to compete on price (which is to say, expense ratios), there’s never been a better time to not only expose yourself to international markets, but reduce price movement risks while doing so. Deutsche Bank (NYSE: DB ), iShares and WisdomTree lead the fund creation march now, but IndexIQ is the first to look outside the standard currency-hedged product box in the quest for differentiation and further investor assets. Its recently launched lineup of 50% currency-hedged ETFs each hedge approximately 50% of its foreign currency exposure to mitigate the effect of currency fluctuation on USD index returns rather than the traditional 100% hedge. These kinds of iterations on a theme will only offer investors further options when considering a currency-hedged strategy. Stay tuned for part 2 next week, which will focus on the rise of robo investors and how this industry will affect ETF investors and continue to grow in 2016.