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Falling in love with a company, its services or its products is well-known to cause its stockholders more financial harm than good. Avoiding this trap is a common advice. And it's a good one.
A Concrete Example
As a real past example, let me tell you about when I invested in Jamba Juice (JMBA), the smoothie shop that is so ubiquitous and keeps expanding. I thought the concept was great. After all, being from Brazil, I know how popular freshly-squeezed fruit juice and smoothies are over there. The fact that Jamba was aggressively expanding outside of its home state of California was a big plus.
This was back in 2005, and I had just discovered Jamba Juice. I immediately fell in love with the idea and wanted to invest in it. But Jamba was a private company back then and all they gave me was a discount coupon when I offered to invest some money into the company. Silly me.
So I waited for its IPO and then waited some more for the post-IPO hype to die down. In 2007, I finally decided to buy, based on its expansion plans, and a lot of excitement about its products and business model. After all, who wouldn't want to buy a Jamba Juice smoothie?
Result?
Price paid: $6.49 per share in 2007.
Current price: $2.37.
Maximum price in the last two years: $3.83.
Dividends paid: $0.
Now you do the math.
What went wrong? First, I didn't stop to analyze the market. I assumed everyone must love smoothies. But it turns out that outside of California, Hawaii and Florida people don't care as much about smoothies. Moreover, only during the summer months do people care enough to look for Jamba's colorful stores. Also, Jamba's expansion plans were so aggressive and it expanded so quickly that it had to close some poorly-performing stores, hurting the bottom line.
And how could this business model be so popular in Brazil? Despite the weather differences, juice and smoothie shops in Brazil typically freshly squeeze their fruits in front of customers, while Jamba mainly freshly blends fruit concentrate with a sugary "dairy base", according to their own in-store information.
I took my losses on JMBA today, after keeping a shred of hope for the last 3+ years.
Conclusion: it pays to look beyond products and services before investing. Look at the market, management quality, financial situation and company expansion plans.
Avoiding a Current Trap
With the lesson learned from Jamba Juice, I recently avoided a similar trap.
I'm a big fan of Vitacost, my supplier of vitamins, herbs, protein, etc. Their products have the lowest price, they ship super fast and their customer service is great. In fact, over the many years I've been using them, I've only had two minor problems with shipping, which they resolved so quickly and satisfactorily that I even wonder if they caused the problem on purpose so that I would fall in love with their speedy customer service.
Sounds like an ad for them, right? But I'm in no way affiliated with them. And that's for the betterment of my pocket.
You see, I wanted to invest in Vitacost for a while and like with Jamba Juice, it was still private when I first thought about investing in them. Today, I discovered that they've been public since 2009, ticker VITC. So I started looking into a possible investment.
Even before turning to their financials I find a slew of terrible news about the company. First, it failed to file for the required paperwork with NASDAQ and it is at risk of being delisted. The CEO has left recently, and it is postponing its shareholder meeting. Worse, it's being sued by not one, but three law firms for security irregularities. Something about its executive team having allegedly lied about its products, services and financial strength to mislead investors into a higher valuation.
Of course, all the bad news could mean that the stock price is depressed and when things are resolved this could be a terrific opportunity to buy. However, for a company with such short track record and with so many problems accumulating right out of the gate, I can't even start considering an investment in it.
I will continue to enjoy Vitacost's good product selection and quality service. But I'm not buying any piece of the company any time soon.
Conclusion
The advice "don't fall in love with your stock" is a good one. Treat all your investments as anonymous machines working for you. If they fail to work for your best interests, it's time to replace them. There's a large pool of good ones out there. All you have to do is do your due diligence, look at the fundamentals and choose carefully.
Disclosures: No position in any of the above mentioned securities as of the time of writing.
Showing posts with label fundamentals. Show all posts
Showing posts with label fundamentals. Show all posts
2011-02-09
2009-11-01
Dividend Discount Model in Action -- LLY Stock Analysis
Recently, I noticed a stock on my watch list that hasn't returned to its pre-financial-crisis level: Pharmaceutical company Eli Lilly (LLY). Here's my analysis.
For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.
LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.
Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.
If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.
LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.
LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.
Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.
Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.
Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.
Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.
Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.
Disclosures: No shares of LLY held at the time of writing.
For a mature dividend aristocrat such as LLY, the dividend discount model is usually a good start in valuing the stock.
LLY has raised its dividend for over 25 years. Over the last 10 years, LLY has raised its dividend a compound 7.86%. Year-over-year, the minimum raise has been 4%, the maximum 13% and the average raise was close to 8%.
Meanwhile, earnings per share (EPS) growth has only compounded by 1.65%. So the growth in dividend is probably not sustainable without further improvements to the bottom line, such as cost cutting or acquisitions.
If we assume a 1% growth in dividends (to match the growth in EPS) in perpetuity, and tag it with a 9% discount (my minimum expected return from solid stocks), the dividend growth model yields a price of $25.
LLY currently trades at around $34, has a forward P/E of 7.8 due to analysts-expected EPS of about $4.25 for 2009.
LLY's 10-year average EPS is only $2.00, though. The growth expected this year and next is attributed to a strong drug demand, the acquisition of ImClone and cost cutting. The company's own EPS guidance for 2009 suggests EPS between $4.20 and 4.30. It's unclear how sustainable this new EPS level is.
Historically, LLY P/E ratio has been quite high: the average low P/E was around 22 while the average high P/E was 34. Counting on market euphoria to bring the P/E back to its historical lofty levels is never a good idea. My comfort range of P/E for a large and mature company such as LLY is between 10 and 15. Using LLY's average 10-year earnings of $2.00, we get a price tag of between $20 and $24.
Looking at dividend and EPS growth and checking the P/E ratio is only part of the analysis. I said earlier that it's usually a good start because mature companies such as LLY often have stable earnings, growth, debt load and share count. But a further look at the balance sheet is always helpful. Consider the trends in the graph below.
Looking at various balance sheet indicators as a percentage of sales can help spot worrisome trends. In this case, it's encouraging to see that both research and development (R&D) and accounts receivable have been moving inline with sales. Inventory had a run up in the past that warrants further investigation, but doesn't appear to be out of control. Selling, general and administrative expenses (SG&A) have been growing slightly faster than sales, which might indicate that LLY is not as efficient as it used to be 10 years ago. Nonetheless, the trend is not sky-rocketing either.
Overall, these trends are somewhat reassuring that the dividend discount model is meaningful as it shows the fundamentals are not quickly deteriorating.
Conclusion: from a purely dividend discount valuation and a check against a conservative P/E multiple and a conservative EPS estimate, my initial fair value for a share of LLY is between $20 and $25. Further investigation into drugs in the pipeline, patent expiration and integration of acquisitions is necessary to further determine earnings power and hence fair value.
Disclosures: No shares of LLY held at the time of writing.
2009-09-18
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:
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:
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:
Know the value of what you own.
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.
2009-07-14
When to Sell?
"Should I sell?" A fellow investor recently asked me this question. It is probably the hardest question for a long-term, buy-and-hold investor to answer. His question was about bonds in particular. He had some nice gains and was tempted to sell, since his bonds had stopped moving up for a while.
I thought for a bit and told him to hold on. But I didn't do a great job at explaining why.
After thinking some more, I came up with the three rules below. They may sound familiar. But bear with me because I arrived at this answer by distilling a few things I've experienced, learned, and believe in; not by repeating what others have written. If my rules sound similar, well, I won't get credit for being the first one to write about them.
So, here's a better answer to "when to sell". Sell when:
I usually sell bonds or bond funds when price is above par and I have doubts about the fundamentals (see also item 2. below). I never buy bonds at par, I always insist on a discount, no matter what the "fair market value" might be. But this is just me. Therefore, to remain consistent, I begin considering selling my bonds when they reach or go above par. If I'm positive of their fundamentals and the yield is still attractive (which, at an above par price they seldom are), then I may hold on for a little bit longer. But if the price gets ahead of par plus future coupons discounted, then the bond is gone.
For stocks, this rule is hard to apply. I usually start with rule 2. below. But if prices get too bubbly, I'll will probably sell at least my weaker companies.
Fundamentals have changed. If my estimates of the prospects of a company change, I usually reassess the value of my holdings. If the new intrinsic value is below the current price, then rule number 1. above dictates I should sell. It's that simple.
Reasons why fundamentals change abound. A few examples: critical management leaves on bad terms; the annual or quarterly report becomes hard to decipher; fraud is found to be pervasive within management; the assumptions about future prospects change materially.
One reason I usually don't worry much is if a product or line of products fails to materialize. That's because I mostly ignore promises of future products in my analyzes. So a new drug not being approved by the FDA should not have a material effect on my analysis of a pharmaceutical company, even though it typically does for Wall Street analysts. The same is true of new "hot" products such as Apple's next iPhone or whatever else tech companies might have promised investors.
When you are bored in a rallying market. I know this is controversial, but let's be honest, everyone gets overconfident sometimes. Saying you shouldn't time the market is good advice, but it's almost impossible to follow. So let's make sure that if you do time the market, that at least you don't attempt to pick bottoms or tops, but that you simply have a profit and a reason to sell.
Originally, I was going to write this rule as "when you need to raise cash in a rallying market". But what is needing to raise cash if not being bored with the returns on your portfolio? Sure, emergencies. But that aside, raising cash usually means you found other investments that may be more attractive.
So, it's fine to rotate out of some investments if the market is rallying, you're ahead and you've found something better. The rule is: a) the market is going up and b) you have gains in the securities you want to sell and c) you have a more attractive investment to make and d) you follow the rules for buying (more on that later).
That way, you avoid: a) selling at major bottoms, b) losing money, c) limiting your gains, and d) buying without a reason.
And that's the only time you're allowed to be so foolish as to try to time the market or sell for a bad reason (being bored).
But let me re-iterate the third rule again: when you're bored and trying to time the market at least make sure the market is in your favor -- sell high -- sell during market rallies at a gain, never at a loss. Then, make sure you have something else in mind. Cash is not an option. Taking your gains just because you have them doesn't make sense. After all, if you did your homework right, you should expect to have even larger gains in the future. So sell only because you've found something better. And again, at a profit.
I hope my fellow investor didn't sell his bonds, but that if he did, he sold them at a gain to immediately buy something better, perhaps an undervalued stock of a profitable and growing company.
I thought for a bit and told him to hold on. But I didn't do a great job at explaining why.
After thinking some more, I came up with the three rules below. They may sound familiar. But bear with me because I arrived at this answer by distilling a few things I've experienced, learned, and believe in; not by repeating what others have written. If my rules sound similar, well, I won't get credit for being the first one to write about them.
So, here's a better answer to "when to sell". Sell when:
- The price has surpassed intrinsic value.
- Fundamentals have changed.
- When you are bored in a rallying market.
I usually sell bonds or bond funds when price is above par and I have doubts about the fundamentals (see also item 2. below). I never buy bonds at par, I always insist on a discount, no matter what the "fair market value" might be. But this is just me. Therefore, to remain consistent, I begin considering selling my bonds when they reach or go above par. If I'm positive of their fundamentals and the yield is still attractive (which, at an above par price they seldom are), then I may hold on for a little bit longer. But if the price gets ahead of par plus future coupons discounted, then the bond is gone.
For stocks, this rule is hard to apply. I usually start with rule 2. below. But if prices get too bubbly, I'll will probably sell at least my weaker companies.
Fundamentals have changed. If my estimates of the prospects of a company change, I usually reassess the value of my holdings. If the new intrinsic value is below the current price, then rule number 1. above dictates I should sell. It's that simple.
Reasons why fundamentals change abound. A few examples: critical management leaves on bad terms; the annual or quarterly report becomes hard to decipher; fraud is found to be pervasive within management; the assumptions about future prospects change materially.
One reason I usually don't worry much is if a product or line of products fails to materialize. That's because I mostly ignore promises of future products in my analyzes. So a new drug not being approved by the FDA should not have a material effect on my analysis of a pharmaceutical company, even though it typically does for Wall Street analysts. The same is true of new "hot" products such as Apple's next iPhone or whatever else tech companies might have promised investors.
When you are bored in a rallying market. I know this is controversial, but let's be honest, everyone gets overconfident sometimes. Saying you shouldn't time the market is good advice, but it's almost impossible to follow. So let's make sure that if you do time the market, that at least you don't attempt to pick bottoms or tops, but that you simply have a profit and a reason to sell.
Originally, I was going to write this rule as "when you need to raise cash in a rallying market". But what is needing to raise cash if not being bored with the returns on your portfolio? Sure, emergencies. But that aside, raising cash usually means you found other investments that may be more attractive.
So, it's fine to rotate out of some investments if the market is rallying, you're ahead and you've found something better. The rule is: a) the market is going up and b) you have gains in the securities you want to sell and c) you have a more attractive investment to make and d) you follow the rules for buying (more on that later).
That way, you avoid: a) selling at major bottoms, b) losing money, c) limiting your gains, and d) buying without a reason.
And that's the only time you're allowed to be so foolish as to try to time the market or sell for a bad reason (being bored).
But let me re-iterate the third rule again: when you're bored and trying to time the market at least make sure the market is in your favor -- sell high -- sell during market rallies at a gain, never at a loss. Then, make sure you have something else in mind. Cash is not an option. Taking your gains just because you have them doesn't make sense. After all, if you did your homework right, you should expect to have even larger gains in the future. So sell only because you've found something better. And again, at a profit.
I hope my fellow investor didn't sell his bonds, but that if he did, he sold them at a gain to immediately buy something better, perhaps an undervalued stock of a profitable and growing company.
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