Real Estate in the Seattle Area Not That Great Either

A while ago I spent some time collecting anecdotal evidence of the poor state of the commercial real estate in California, more specifically in the Silicon Valley.

This time, I have a few photos from the Seattle area. I didn't collect a whole lot of pictures because that takes time. But I did see a lot of "for lease" and "space available" signs all over the city. Here are a few of them.

None of this proves anything, but it's just interesting to notice. I don't recall seeing similar signs last time I was in Seattle, in 2001 (and that wasn't a great time for the economy either).


Judging management quality quantitatively

Assessing management quality of companies is one of the hardest things for me to do when I'm valuing a stock. Valuation is hard and subjective on its own, but when it comes to assessing management quality it is even more subjective.

However, there are a few quantitative tests to help an investor gauge management quality. I find them helpful as a "red flag" kind of measurement. Here are a few things to look for.

Does management make more money than shareholders?

Look at management compensation disclosures in form 10-k (sometimes it's part of the proxy statement filed under form DEF-14A, sometimes in other places too, depending on the company -- some ADRs do it differently too).

How much money is management making in comparison to the company itself? If management collectively makes more money than is left for shareholders, it's a clear sign of improbity -- stay away.

Does management get raises regardless of how shareholders fare?

In other words, is compensation aligned with shareholders results? Look for how options are granted, at which strike price: fair market value or some other made-up value that is likely to benefit management only at the expense of shareholders?

Look for the criteria how stock options are granted. Is it purely share price or earnings based? Or there are more objective criteria such as long-term trends, ROI, cost reductions and margins (such as operating margin)?

Also: is management compensation growing faster than dividends? That could be a warning sign.

Are ROE, ROI, ROA trending up or down? Are they satisfactory for the industry?

Good ratios tend to show good management, but don't forget to factor in peculiarities of each industry as well. While ROE will typically be bad for companies in a bad industry such as airlines, huge disparities in ROE for example can mean excessive risk (high leverage) or poor management. For banks, low ROA (1-2%) is okay, but too low and management is probably doing something wrong.

Did the stock price reflect at least $1 for each $1 of retained earnings?

This is a Warren Buffett's favorite. If the share price over the long run (say 5-10 years) hasn't fully appreciated $1 for each dollar of retained earnings, it means the company is being undervalued by the market, which could happen for two reasons: 1) the market is consistently irrational and it's probably time to buy, buy, buy or 2) the market has little faith to believe the retained earnings will be deployed wisely (say, management is likely to waste money on acquisitions or endeavor into money-losing strategies) .

You have to figure out for yourself what's the case here, but over a very long time, if the stock price fails to reflect at least the retained earnings it's most likely a reflection of poor management.

Don't forget to take into account dividends. If dividends were paid, these were not retained earnings, so they should be factored out.

Does management capitalize things that should be expensed?

Capitalizing an expense is putting the expense as an asset on the balance sheet and depreciating (taking charges against it) over time. Capitalizing an expense is an aggressive way of managing the company's financials and is typically wrong, no matter what the explanation. AOL once capitalized its advertising costs, under the excuse that advertising was an investment for the long-term and that it would eventually earn its fruits over time. While this can be true, it's not the proper way of reporting an expense, which is what advertisement is.

The best way to think of this is the following: does it involve an outlay of cash? If so, it's an expense. Period. The only exception is goodwill, which is the amount companies overpay for assets (when they acquire other companies, for example). But even then, a lot of goodwill on the balance sheet is probably not a good sign either.

Do earnings come from "other" sources?

If an airline makes the bulk of its money by trading fuel in the futures market and not by operating airplanes to transport people and goods, then its earnings do not reflect its line of business. While this is an obvious example, in many cases it's hard to assess what is part of recurring revenues and what is extra income from "other" sources.

Too many gains from trading in financial markets doesn't bode well for a non-investment or holding company.

Watch out for too large financial transactions for non-financials, making money on fees paid by franchisees, or even the unscrupulous and dishonest practice of lending of money to subsidiaries just to have it come back again as dividends from these same subsidiaries (trust me, it happens).

Does management try to obfuscate (bad) financial results?

If a company's financial report contains any of these:
  1. Too hard to decipher;
  2. Too many one-time items that smell like recurring items;
  3. Too many off-balance-sheet commitments;
  4. Lots of related-party transactions that benefit management's family and friends but are not in the main interest of shareholders;
  5. Contains too much accounting gimmickry, constant changes in accounting procedures or excessive and unnecessary use of accounting lingo.
These are strong clues that management is not trying to help you assess the true worth of your company. Vote them out or get out.

Does management think and act like owners?

This one is very subjective and more qualitative than quantitative. But it means that if throughout reading a company's annual report you find yourself thinking that management is not candid about the company's current situation (if it's poor), if it's too optimistic, conceals or minimizes bad news or overall gives you an impression that they're not doing what you as a shareholder would do, then jump ship -- you're likely dealing with a prima donna and not a true owner.


Following the newest fad usually leads to destruction of value

It is widely known that fad investing usually leads to lost money and time.

It is also known (perhaps not so widely) that when companies try to follow the newest fad they also end up wasting shareholder's money.

One such situation I read a long while ago was at the height of the dot-com era. It was then considered a sign of financial stability for tech companies to buy or sponsor stadiums, baseball teams and other sports-related endeavor. This typically led to companies wasting money and making malinvestments outside of their core expertise. These malinvestments may not have caused huge concerns for companies like Oracle, HP and AT&T (major sponsors of places such Oracle Arena, HP Pavilion and AT&T Park), but nonetheless were wasteful.

Another typical sign of fads are when companies start renaming themselves to be associated with the current "newest thing" or "hottest industry". In The Intelligent Investor, Ben Graham mentions companies that switched names to include prefixes such as "electronic", "computers", and "franchise", just to lose a lot of money afterwards. During the dot-com era, companies changed stock symbols (Sun adopted the ticker JAVA), mottos (again, Sun adopted "We're the dot in dot-com") and others even adopted prefixes such as "e-", "i-", "wireless" and "optical". All were destined to overvaluation and then doom.

So, when I hear that everyone and their moms is starting up a "social networking" site, I get really skeptical. The latest one was WD-40, the company that makes the popular lubricant by the same name. While I think WD-40 has strong pricing power on their main products and at some price would be a great investment with a moat, I grow suspicious when such brick-and-mortar companies try to venture into things like social networks.

My opinion of social networks (the legitimate ones such as Facebook) is pretty low already. When one comes from an old lubricant company, I know something must be fundamentally wrong with management. At the very least, I would require an extra margin of safety on top of my current one to invest in a company that wastes time, money and effort with such fads. At 20x earnings, I'm passing on WD-40 for now, despite its somewhat attractive dividend yield and pricing power.


Alternative valuation methods are harmful to one's pocket

Ben Graham taught us to look for discounts to net current asset value in order to protect against large declines in stock prices. Net current assets are current assets (cash and equivalents) minus current liabilities (all debts to be paid within a year).

But despite this method being proven to provide good results with minimal downside, people still choose to dream up their own convoluted valuation methods for investment.

Consider for example the use of the "eyeballs" metric at the peak of the dot-com bubble. Firms with no income were being appraised based on the number of people visiting these companies' web sites. That can barely show potential for future revenue, and it says nothing about real earning power nor what matters, profit-making.

While "eyeballs" seems ridiculous in hindsight, it wasn't questioned by many back then.

Other unproven valuation metrics are created all the time. Consider for example "economic goodwill". It states that the difference between market capitalization (share price times number of shares outstanding) and net tangible book value is the amount of "additional value that the market has assigned to a company, based on intangible assets, such as quality of management, growth prospects and efficiency of operations, that don't appear on a balance sheet".

The theory was that the lower this amount compared to the average of return on assets, return on equity, debt-to-equity ratio, and percentage growth of earnings divided by percentage growth of revenue, the cheaper a company would be.

This one study from 2000 thus picked the 10 most undervalued companies back then based on this metric, as shown below. The number in parenthesis is the return on their market price from 2000 until now.

American Power Conversion (-100% -- delisted)
Computer Associates (-74%)
Intel (-77%)
Microsoft (-58%)
Pomeroy (-81%)
Symantec (+63%)
Tellabs (-92%)
Verisign (-92%)
Viant (-100% -- delisted)
Xilinx (-78%)

To be sure, no valuation shortcut is infallible. Ben Graham never said the net current assets method can prevent loss. It can't, since the future is and will always be unknown. But if anything, it provides the best protection one can get short of clairvoyance.

People should be happy to buy dollar bills for fifty cents. Anything else is speculation.


Why is the market rallying?

With so much bad news out there, why is the market rallying?

Here is my theory -- don't be shocked, it's nothing new really, just putting some data in context.

My theory is that expectations were low, very low. Lower than reality.

I follow earnings announcements for all reported companies on EarningsWhispers. And I happened to notice that the overwhelming majority of earnings news in the last two months have surprised on the upside (I have not computed a formal metric on this since it would actually involve counting and I'm not in a counting mood right now). My estimate is that at least 80% of companies came out with earnings "above estimate", about another 10-15% were "below estimates" and the rest "inline".

Another way of saying this is that the bad news has been baked into prices for a while -- the stock market being the forward-looking machine it is. And reality wasn't so bad after all. Many market participants are seeing the light at the end of the tunnel.

That doesn't mean we won't have an incoming train at the other end of the tunnel run us over. But it does explain why the market is rallying recently.

Sadly, none of this matters. No one knows what will come next. My best guess is that the two most likely outcomes are:
  1. This rally will stop very soon and we'll move sideways for a number of years, until inflation catches up with us and eats away the current returns, without many noticing (that's what the government wants to happen so that they get out of their enormous debt by devaluing it).
  2. The market is now adjusting to the current increased expectations just to be disappointed soon, given that the economy is nowhere near improving. Then the stock market will crash again.
Neither one of these outcomes is good for the short-term.

My reaction? I bought some TIPS last week. It's the only true "safe" investment if you earn in dollars and pay your bills in dollars.

But I won't stop there. I'm still planning on what to do next and it might just be "nothing", which is my favorite move most of the time.