Recency Bias and One-Time Gains

Stocks have value for two reasons only: 1) their liquidation value (what their assets are worth after subtracting what they owe) and 2) because of the expectation of future earnings.

Regarding 1), it's uncommon for stocks to be valued purely based on their liquidation value since most companies are not meant to be liquidated, but rather to continue as going concerns.

Regarding 2), a stock's history of earnings has no bearing on its future value other than as a proxy for what it could earn in the future. But if the future prospects for a company are really dim, then no glorious history of past earnings can lift the stock much beyond liquidation value.

So what does all of this has to do with recency bias and one-time gains? Well, everything. First, businesses, like life, have their ups and downs. So the recent past might not be a good proxy for judging the future earning power of a company. Even though this is stating the obvious, Wall Street too often forgets this and assigns too much weight to recent events such as improved earnings, one-time gains, a rough patch, etc.

Think about it: The past is bounded, but the future is unbounded. So what a company did last quarter or what it will do next quarter should have close to zero effect on its value in perpetuity.

In summary, when appraising a company, make sure to adjust one-time gains (or charges) and look at earnings over a long period of time (at least 5 years, typically 10 or more) to smooth out recent effects. Averaging the returns after adjusting them can also help you gain a basis for projecting future earnings.

At the same time, make sure to discount recent events that may not have much long-term meaning such as launching new fad products, some types of planned changes in management (especially when a successor has been groomed for many years) and small divestitures or acquisitions of subsidiaries that are unlikely to have a material impact.

When recent changes appear meaningful, ask yourself whether or not they fundamentally change the characteristics of the business on a permanent basis. Is buying that piece of equipment or installing that computer system going to enable the business to earn more or keep more of what it earns permanently in the future? Does it change the nature of the business?


Don't Confuse Price for Value

Philip Fisher was a great investor. Despite his focus on growth, he was well aware that the more you pay the less you keep, and hence the smaller your returns will be. Fisher also warned his readers that price and value are not equal and that just because a stock's price has been stable for a long time does not mean that a) it's correct nor b) that it can't change when events change or the market's mood swings.

Here's a paragraph from his book Common Stocks and Uncommon Profits that I find extremely important and possibly one of the main "hidden" lessons in the book:

When for a long period of time a particular stock has been selling in a certain price range, say from a low of 38 to a high of 43, there is an almost irresistible tendency to attribute true value to this price level. Consequently, when, after the financial community has become thoroughly accustomed to this being the "value" of the stock, the appraisal changes and the stock, say, sinks to 24, all sorts of buyers who should know better rush in to buy. They jump to the conclusion that the stock must now be cheap. Yet if the fundamentals are bad enough, it may still be very high at 24. Conversely, as such stock rises to, say, 50 or 60 or 70, the urge to sell and take a profit now that the stock is "high" becomes irresistible to many people. Giving in to this urge can be very costly.

Fisher goes on to explain that fortunes are made when stocks are let go many times higher than what the investor paid for the stock, precisely because he bought them when they were undervalued or fairly valued and growing. He also added:

The only true test of whether a stock is "cheap" or "high" is not its current price in relation to some former price, no matter how accustomed we may have become to that former price, but whether the company's fundamentals are significantly more or less favorable than the current financial-community appraisal of that stock.

This rings true with value investors and growth investors as an investor is he or she who makes intelligent decisions about investments, and does not speculate on market events that have no bearing on the true value of a company.

The danger of getting too hooked up on price is so high that Fisher introduced its "influence" as follows:

This influence is one of the most subtle and dangerous in the entire field of investment and one against which even the most sophisticated investors must constantly be on guard.

Know the value of what you own.


Mini-Tender Offers: Awful Deals in Disguise?

From time-to-time my broker sends me correspondence regarding various types of "unsolicited tender offers" and "non-mandatory reorg tender offers". These are also known as mini-tender offers. You can read more about them in the SEC's site. They're basically offers by some company or private party to buy less than 5% of the outstanding shares of a public company directly from shareholders.

Okay, so what's the deal?

These "offers" are typically below market-value offers. They can be legal scams in disguise. Basically, weak retail investors will hear the term "tender offer" and will jump the gun in excitement and agree to surrender their shares for less than they could get in the open market!

In the last few months I got one such offer for shares of Bank of America (BAC). And more recently, one for Pepsi (PEP). When I first read the one for Pepsi, I almost thought it had something to do with Pepsi's acquisition of one of its bottlers, Pepsi Bottling Group (PBG) or PepsiAmericas (PAS). Then when I stopped for 3 seconds to think about it, I realized it couldn't be: I don't own shares of either PBG nor PAS. This must be someone trying to buy PEP (the syrup maker) from me. Why?

Another 3 seconds revealed the truth: some funny people at a company called TRC Capital Corporation are offering to take my shares for a discount to market! How awesome is that?

Why would anyone fall for this, you ask?

I don't know. They're probably the same type of eager people who fall for "a one-time business opportunity with the president of Nigeria".

This is what Pepsi had to say about the offer:
PepsiCo does not endorse TRC's unsolicited mini-tender offer and recommends that shareholders not tender their shares in response to this mini-tender offer.
In other words: what a steal! You can read Pepsi's note in full here.

Don't pull the trigger without a bit of investigation. Most offers are not what they seem to be.

Read more about the man behind TRC.

Disclosure: I own shares of PEP, BAC at the time of writing.

Don't Let Your Investment be Diluted

This article originally appeared on The DIV-Net on 2009-09-02

High return on equity (ROE) and a reasonably high dividend yield are good things to have in stock investment. But investors focusing on just these two metrics (or any other few metrics) might be surprised to discover they are losing money.

This is the case of CenterPoint Energy (CNP), a utility company with interests in electricity, natural gas distribution and pipelines. Since 1999, CNP has returned $8.78 per share to shareholders via dividends. The average annual dividend yield since then has been between 3.11% and 6.83%.

The return on equity has been solidly between 10.3 and 34%, with the average just over 21%, which is pretty good considering that an average business gets less than 12% and utilities are lucky to strike above 8% ROE.

But long-term investors received little for holding the stock for the last 10 years. In fact, they lost money after inflation, through equity dilution.

An investor who was lucky to buy a share of CNP in 1999 at the lowest recorded price for that year ($22.75) and held on until the very peak price in 2008 ($17.35), would have gotten a total cumulative return of around 8%, including dividends, which translates to 0.89% annualized. That's less than inflation.

Even if we consider that in 1999 the market was very inflated and in 2008 it was really low overall, this exercise assumed an investor was lucky enough to buy at the trough and sell at the peak. Most investors won't get these prices.

But let's exclude 1999 as it was a local market peak and also 2008 since it was an abnormally depressed year. Let's continue to assume our investor was lucky and bought at the lowest point in 2000, collected dividends until the top of 2007 and sold at that high price.

Even in this scenario, the cumulative return amounts to only 24% or 3% annualized, barely keeping up with inflation.

The table below summarizes why.




Price: High$32.50$49.00$50.45$27.10$10.49$12.32$15.14$16.87$20.20$17.35


Price: Low$22.75$19.75$23.27$4.24$4.35$9.66$10.55$11.62$14.70$8.48


Dividend per Share1.501.501.501.070.400.400.400.600.680.73


ROE (%)3414.314.810.326.414.418.730.323.723.2


Yield on avg price5.43%4.36%4.07%6.83%5.39%3.64%3.11%4.21%3.90%5.65%


Shares outstanding286284292299306364336324341343


Long term debt$5,666$5,701$6,448$9,149$10,783$7,193$8,568$7,802$8,364$10,181



$ Return% ReturnAnnualized


Return from 1999 low to 2008 high$1.888.26%0.89%


Return from 2000 low to 2007 high$4.8224.41%3.17%

CNP has been diluting shareholders returns via stock options and outright sale of stock and at the same time maintaining or increasing its debt. These management actions proved to be unfriendly to shareholders and thus investors should continue to shun this stock.

Dilution of shares and high debt are characteristics of capital-intensive companies with high fixed charges. Careful investors should be on the look out for such companies and invest only when it makes sense to do so.

Value investing is not only about finding bargains. It's about finding wonderful businesses at reasonable prices.

Disclosure: no position in CNP at the time of writing.