What to Do When Earnings Torpedo Sink Your Portfolio and When You Are Misunderstood? From Bezos and Jobs to “Asia’s Overlooked Amazon”, A Guide for Value Investors – Bamboo Innovator Weekly Insight
August 24, 2015 Leave a comment
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Bamboo Innovator Insight (Issue 97)
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| Dear Friends,
What to Do When Earnings Torpedo Sink Your Portfolio and When You Are Misunderstood? From Bezos and Jobs to “Asia’s Overlooked Amazon”, A Guide for Value Investors Don’t let an earnings torpedo sink your portfolio! This is the metaphor coined by accounting researchers Douglas Skinner and Richard Sloan in their controversial paper describing their evidence that the market overreacts sharply and suddenly to announced earnings that fell just short of the analysts’ consensus earnings forecast (i.e. a torpedo effect), and that the effect is more pronounced for “growth stocks”. Hence, while “growth stocks” outperform during “boom periods” with relatively low frequency of negative earnings surprises, they underperform on average relative to “value stocks”. Fears of the torpedo effect also explained why managers tend to play the earnings game to meet or beat the threshold numbers. This practical metaphor comes alive for many investors with the recent heightened volatility in the emerging markets reminiscent of the 1997/98 Asian financial crisis. Even Buffett-invested Deere & Co (NYSE: DE) got hit after it announced last Friday on 21 Aug that third quarter earnings tumbled 40% and its net income for the fiscal year through October will be about $1.8bn, less than the $1.9bn that Deere forecast in May and the $1.92bn average of 11 analysts’ estimates, as lower crop prices weakened the farm economy and the energy industry bought less of the company’s construction machinery. Interestingly, its EPS of $1.53 had beaten the $1.44 average estimate. It is also worth noting that since the beginning of its 2012 fiscal year, Deere has beaten the analyst consensus on 12 out of 14 occasions and the last 10 in a row. Yet its shares have actually fallen following 11 of those 14 results. So the bar has been raised from a simple EPS estimate to a composite measure of forward-looking forecasts in revenue, earnings and outlook. This time round, with the lowered full year forecast, Deere was punished – its shares fell the most intraday in six years, plunging 7.9%. What can value investors do to overcome such painful and frightening earnings torpedo?
The answer perhaps lies in what the researchers left unanswered: Why did they miss the forecast? How will, and how do, the managers and entrepreneurs react after they announce bad news? A key word to unlock the practical investment puzzle is “misunderstood”. Is the company misunderstood in the eyes of the majority consensus? For instance, is the company missing its revenue and earnings forecast because it is making long-term investments that incur costs to impact short-term earnings or in new project initiatives that do not contribute meaningfully to the bottom-line yet? Or is the miss due to a restructuring in sales and product mix? Let us consider the cases of Amazon.com, Steve Jobs and “Asia’s Overlooked Amazon” as a general guide for value investors to think deeper about and respond to the frightening earnings torpedo. Amazon.com (NASDAQ: AMZN) has endured and outlasted critics. The online retail giant has also sunk in multiple earnings torpedo incidents, missing Wall Street forecasts as shown in the table below, and went on to outperform in the longer-term.
Misunderstood could be the word that plagued Amazon and Bezos throughout its history. Amazon recently came under fire after a New York Times article Inside Amazon: Wrestling Big Ideas in a Bruising Workplace on 15 Aug 2015 slammed its “thrilling, bruising” workplace environment, describing Amazon as “a soulless, dystopian workplace where no fun is had and no laughter heard” in which people are encouraged to belittle their colleagues, and where leaving work to recover from cancer earns you a demerit. The NYT writers also described Bezo’s penchant for data-driven management with a story that Bezos himself shared in speech to Princeton grads: “Jeff Bezos turned to data-driven management very early. He wanted his grandmother to stop smoking, he recalled in a 2010 graduation speech at Princeton. He didn’t beg or appeal to sentiment. He just did the math, calculating that every puff cost her a few minutes. ‘You’ve taken nine years off your life!’ he told her. She burst into tears.” The NYT ends the story there, drawing a broad conclusion from 10-year-old Bezos’s behavior: “Decades later, he created a technological and retail giant by relying on some of the same impulses: eagerness to tell others how to behave; an instinct for bluntness bordering on confrontation; and an overarching confidence in the power of metrics.” What the NYT writers fail to mention is that Bezos was using the story to illustrate an important and inspiring humane lesson. Bezos expected to be praised for his math in the offending comment “at two minutes per puff, you’ve taken nine years off your life!” When Bezos’s grandmother “burst into tears,” his grandfather stopped the car on the shoulder of the highway and delivered a line that stayed with Bezos 46 years later. “Jeff, one day you’ll understand that it’s harder to be kind than clever,” his grandfather said. Bezos went on to say that students should not be “seduced” by their gift of intelligence: “Cleverness is a gift, kindness is a choice”. Bezos drew contrasts between choosing “a life of ease” and “a life of service,” and he asked students to consider whether they would “wilt under criticism” or “follow [their] convictions”. Critics of Amazon abound early on since it was established in 1994. When Amazon was still relatively small, Bezos build five $60M automated fulfilment centres in 1999 against the advice of experts: “for a company that only had $1bn in sales, spending $300m on fulfilment centers is a very big investment.” In 2000, its estimated warehouse capacity was three to five times more than it needed. In 2001, sales had fallen short of expectations, two of its distribution facilities were closing, and Amazon had to lay off 1,300, or 15%, of its employees. Pundits and critics predict the death of Amazon. A breakthrough came in 2002 when Amazon embarked on a strategy of broad discounting and free shipping (for purchases >$25) rather than spending money on marketing ads as advised by experts, dramatically increasing sales, decreasing the operating leverage and risk associated with Amazon’s fixed costs while more fully utilizing its newly-developed distribution network. Following his convictions led to many people to misunderstand Bezos and also nearly led to the demise of Amazon. Bezos summed up the “willingness to be misunderstood” as the acid test to overcome ongoing volatility and critics: “Our willingness to be misunderstood, our long-term orientation and our willingness to repeatedly fail are the three parts of our culture that make doing this kind of thing possible”. We also shared with various Asian entrepreneurs over the years about the story of Amazon and Bezos, including a forgotten tale about the “humane” side of Bezos. In 2004, Bezos was visiting an Amazon fulfillment center with his leadership team. During the visit, he heard about a safety incident when an associate had seriously damaged his finger on a conveyor belt. When Bezos learned of the incident, he walked to the white-board and began to ask five whys to get at the problem’s root cause: Q1: Why did the associate damage his thumb? A: Because his thumb got caught in the conveyor. Q2: Why did his thumb get caught in the conveyor? A: Because he was chasing his bag, which was on a running conveyor. Q3: Why was his bag on the conveyor and why was he chasing it? A: Because he placed his bag on the conveyor, but it then turned on by surprise. Q4: Why was his bag on the conveyor? A: Because he used the conveyor as a table for his bag. Q5: Why did he use the conveyor as a table for his bag? A: Because there wasn’t any place near his workstation to put his bag or other personal items. Bezos and his team determined that the likely root cause of the associate’s damaged thumb was needing a place to put his bag but not having one around he used the conveyor as a table. To eliminate further safety incidences, the team provided a portable, lightweight table at the appropriate stations and additional safety training to alert associates about the dangers of conveyor belt work. While this innovation was minor, Amazon member Pete Abilla said it was a transforming experience “that I carry with me to this day.” The incident showed that:
Bezos wanted Amazon to be a place where people are committed to their work like a vocation and are willing to embrace risk and strengthen ideas by stress test., with leadership principles like “never settle” and “no task is beneath them.” Even relatively junior employees can make major contributions. The new delivery-by-drone project announced in 2013, for example, was co-invented by a low-level engineer named Daniel Buchmueller. In essence, Amazon has provided a platform for those who are fanatics in wanting to build meaningful things as part of a bigger purpose. Consider another misunderstood case: Steve Jobs and Apple. Like Amazon, Apple had also had its fair share of earnings torpedo over the years and went on to compound over the long-term. However, a qualifier is that we noticed that Apple had missed earnings on 17 Oct 2011 after having beaten forecasts in every quarter since 2004. This was after Steve Jobs passed away on 5 Oct 2011. Since the earnings torpedo and Jobs’ death in Oct 2011, Apple is up around 80%, roughly in line to around 70% for the NASDAQ index. The story below will give us further insights on why people like Steve Jobs are likely to be misunderstood for their actions. On a late-October morning in 2010 in the restaurant of the Four Seasons hotel in San Francisco, Steve Jobs and two of his friends were approached by a waitress who asked what they wanted for breakfast. Jobs said he wanted freshly squeezed orange juice. The waitress returned with a large glass of juice after a few minutes. Jobs took a tiny sip and told her tersely that the drink was not freshly squeezed. He sent the beverage back, demanding another. A few minutes later, the waitress returned with another large glass of juice, this time freshly squeezed. When he took a sip he told her in an aggressive tone that the drink had pulp along the top. He sent that one back, too. Jobs’ friend asked him, “Steve, why are you being such a jerk?” This story, told in a New York Times article “What Steve Jobs Taught Me About Being a Son and a Father” by Nick Bilton, who commented that his initial impression was that Jobs is indeed a callous jerk, but added that Jobs had planted an idea in his head that he could shake off after hearing Jobs’ reply. Jobs replied that if the woman had chosen waitressing as her “Vocation”, “then she should be the best.” The idea that Jobs believe strongly in is that: No matter what you do for a living, should you do the best work possible? Bilton went on to share a touching tale of how his mother had later contracted terminal cancer with only two weeks to live. That was when the writer learnt that “even if a job is just a job, you can still have a profound impact on someone else’s life. You just may not know it “. On her final day, Bilton’s mother was craving for shrimps. But they did not have any in the kitchen and the nearest place to get them was a tiny nondescript Thai restaurant a few miles away. While Bilton stood waiting for his mother’s shrimp, he watched the restaurant staff toiling away and he thought about what Jobs had said about the waitress from a few years earlier: the idea that we should do our best at whatever job we take on. Bilton concluded: “This should be the case, not because someone else expects it. Rather, as I want to teach my son, we should do it because our jobs, no matter how seemingly small, can have a profound effect on someone else’s life; we just don’t often get to see how we’re touching them. Certainly, the men and women who worked at that little Thai restaurant didn’t know that when they went into work that evening, they would have the privilege of cooking someone’s last meal… It was a meal that would end with my mother smiling for the last time before slipping away from consciousness.” We can detect the dedication and intensity and sense of urgency that Bezos and Jobs bring towards integrating every aspect of their values into their work and life – and why they are easily and always misunderstood. A key task of the value investor in an earnings torpedo situation is to differentiate the authentic innovators and leaders, from the pretenders who use complex financial engineering schemes to generate short-term results that would eventually unwind in impairment losses. Thus, the case of Bezos and Jobs highlighted that in order to overcome the earnings torpedo, value investors must assess the element of misunderstanding that creates volatility in results and must ultimately be able to pierce through this misunderstanding with an acid test: Are the entrepreneurs committed to building an idea larger than themselves to serve others? Only if the value investor is able to sense and measure this commitment to a Purpose and assess that the economic moat remains intact, then would the earnings torpedo present an opportunity to buy more. This brings us to the final case of “Asia’s Overlooked Amazon”… <ARTICLE SNIPPED> Read more at the Moat Report Asia: http://www.moatreport.com/updates/ ******** In her thought-provoking book “No One Understands You and What To Do About It”, author Heidi Grant Halvorson explains why we are often misunderstood and how we can fix that. Halvorson emphasized that this is not about making good impression, but about coming across as you intend to: “It’s about the authenticity we all strive for”. Two particular “solutions” caught our attention as relevant for value investors to assess the entrepreneurs building the economic moat to last for the long-term but got hit by a short-term earnings torpedo or some other challenges. One of them is “Demonstrate your strong willpower.” Do they internalize the obstacles and challenges, maintain discipline, exercise self-control and demonstrate willpower in overcoming the problems instead of blaming external environmental factors or people? Another is “Emphasize what you can do with some concrete specific details, not what you have done.” This allows the value investor to assess the long-term orientation of the entrepreneurs by combining the Elon Musk strategy discussed earlier on delving into details to assess consistency and depth of thoughts in order to sieve out the pretenders. We can observe this in the concrete details provided by “Asia’s Overlooked Amazon” in their long-term investments in the new businesses. There is a sense that they want to get things going, to get things done. Another common example: Consider the statement that companies involved in alleged accounting irregularities often make, that their accounts comply with the financial reporting standards and Big Four auditors have issued them unqualified opinions, but not addressing the specific allegations in providing more transparency and disclosures behind the “audited” numbers: “No, you can’t hide behind GAAP. GAAP accounting rules are the ones that we all live by and they are very strict. We had both KPMG and Ernst & Young restate that they are ok with our numbers.” This was what Computer Associates’ Chairman and CEO Sanjay Kumar said before he was later sentenced to 12 years in prison for his role in the $2.2 billion accounting fraud. Such broad proclamations, that hide under “compliance” or “track record” or “reputation” but do not address the specific issues that people wish to know more to understand the long-term orientation and integrity of the entrepreneurs in generating the numbers, are essentially a signal of defensiveness, impression-management and evasiveness. To sum up, with Halvorson’s solutions to better understand the context of messages emitted by people in situations of misunderstanding and how the authentic leaders go about fixing them, earnings torpedo present an opportunity to buy more only if the value investor is able to
Read more at the Moat Report Asia: http://www.moatreport.com/updates/ PS1: We have some updates on “Behind the Scene Conversations on Value Investing in Asia” in the Forum: http://www.moatreport.com/forums/topic/behind-the-scene-conversations-on-value-investing-in-asia/. We had a thought-provoking discussion with our existing Institutional Members about stocks that include Singapore-listed Petra Foods; HK-listed Sa Sa International, Great Wall Motor, Sun Art Retail; Taiwan’s Poya, Shin Zu Shing, King Slide, Eclat, Paiho; Indonesia’s AKR, India’s Mayur Uniquoters, Kitex Garments, Page Industries, Mahindra & Mahindra and its listed affiliates, Swiss-listed DKSH vs Li & Fung and its listed affiliates Global Brands Group and Trinity. We believe that for value investing to be productive, there has to be a candid dialogue with a group of people who genuinely care for one another.. Our recent weekly insight article on Mahindra & Mahindra (NSI: M&M, MV $12.6bn) was read by the capable management team at the entrepreneurial company. The Mahindra leaders passed the article to the Mr. Ananda Mahindra himself, who commented that it was “well-written” and “bridges the gap between the investors and the ground realities of managing a business in Asia”, according to the management team whom we had a teleconference with two weeks ago: PS2: We also like to share with you an article “Scouring Accounting Footnotes to Prevent Tunneling” which we penned for our local newspaper Business Times Singapore that was published last week: https://www.smu.edu.sg/BT_20150819_1.pdf Warm regards, KB The Moat Report Asia A new monthly issue of The Moat Report Asia is now available! Access the in-depth idea presentation: http://www.moatreport.com/members/ This month of August, we highlight a listed Asian company who is the #1 functional beverage drinks company in its country with around 40% domestic market share by value and the leading functional coffee powder brand in terms of volume (#2 by value). The company is one of few Southeast Asian consumer firms who enjoy success outside of their domestic market, with overseas exports to over 60 countries contributing over 60% of total sales. The company is still in the early growth stage of deepening its channels in the overseas markets with functional beverage as the fastest growing category driving the growth of the global $200 billion nutraceuticals industry. Nutraceuticals is expected to play a central role in the frontline of the battle for consumer health with the rise in lifestyle diseases and consumers are increasingly making health-conscious choices from cutting down on carbonated soft drinks to switching to natural, organic diet. Gross margin has expanded from 30.3% in 2012 to 39.5% in 2014 with improving production efficiencies and rising higher-margin export sales. EBITDA and EBIT margins stand at 19.8% and 16.6% to generate ROE of 22.8%. The company’s high-capex era has stabilized and will enter into a bigger free cashflow and net cash position going forward. Interest-bearing debt-to-equity has dropped from 1-1.2x in 2012-13 to zero debt and net cash in 2014, with the latest net cash to book equity position at 21.7% in 1Q15, giving it a stronger position to make bolt-on acquisitions of niche nutraceutical companies, including expanding into the functional food category to strengthen its robust portfolio of functional beverage brands. The company trades at historical EV/EBIT 15.9x and EV/EBITDA 13.3x. |
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