Wall Street Journal Recap: February 20-26, 2017

March 6, 2017 / Richard Lewis / Leave a comment

My full notes and analysis on the Wall Street Journal from the past week: February 20-26, 2017 (Week 8). Please Enjoy.

Donald Trump: Pre-Suasion genius?

Is Donald Trump a Pre-Suasion genius? He is constantly criticized for being too vague about the details of his plans and chronically leaving people in a state of uncertainty. But that might just be the key to his success.

Stock markets typically reject uncertainty as a negative force. But in the case of President Trump, markets have embraced a sort of “positive uncertainty”. In his book Pre-Suasion, Robert Cialdini provides a compelling insight which may explain Trump’s strong positive influence on the stock market:

“During the experiment, the men who kept popping up in the women’s minds were those whose ratings hadn’t been revealed, confirming the researchers’ view that when an important outcome is unknown to people, “they can hardly think of anything else.” And because we know, regular attention to something makes it seem more worthy of attention, the women’s repeated refocusing on (the guys whose ratings remained unknown to the women) made them appear the most attractive.” – Robert Cialdini

Now let’s look at an excerpt from an article the other week titled “Federal Reserves Eye Aggressive Rate Increases.” (link)

“President Donald Trump’s plans for tax cuts, new spending and deregulation have buoyed market hopes of faster economic growth and higher corporate profits. But Fed officials at the meeting underscored their uncertainty about the details and effects of the potential policy changes, according to the minutes.”

“A few policy makers also worried that investors betting on tax cuts “which might not materialize” had pushed up equity prices too much.”

Post-Mortem: Glencore and Copper (link)

Copper prices surged more than 30% in the last year and shares in Glencore have more than tripled in the past 12 months. The two biggest drivers in copper prices over this time-period were:

1) China Stimulus: “The metal’s resurgence partially has been driven by a government economic stimulus program in China, where over 40% of the world’s copper is consumed.”

2) Labor Disputes: There have also been “snags at two of the world’s largest copper mines-labor problems at Chile’s Minera Escondida, and a permit dispute with the Indonesian government for Freeport-McMorRan Inc.’s Grasberg mine.”

So I’m curious…how many investors in Glencore identified “China Stimulus” and “Labor Disputes” as the main parts of their investment thesis? My guess is very few.

“Histogram Management”

Charlie Munger once mused about The Kellogg Company that there’s nothing keeping cereal producers from going crazy over market share and tearing each other apart. (link) So when investing in an industry, you have to seriously consider; What force is maintaining rational economic decision-making in this industry?

The CEO of Glencore appeared to be surprised and upset when his competitors weren’t acting rational in the wake of declining commodity prices.

“(Glencore) CEO has long criticized his competitors for ramping up supply in the face of falling prices.” (link)

Such a reaction seems to indicate a lack of understanding of human psychology and the forces that drive rational economic behavior. After all, there are many reasons management would ramp up production in the face of declining prices. Here are four such reasons:

1) Incentive-caused biases linked to executive compensation or job security.

2) Prisoner’s dilemma and the Fear of Missing Out. Which explains why two rational individuals might not cooperate, even when doing so is in their best interest.

3) Social Proof. You look around and no one is cutting production, so this must be the right thing to do.

4) A genuine economic desire to survive. i.e. They keep producing at a loss in order to cover massive fixed costs.

Expanding upon the first point of Incentive-caused bias, management may have a personal economic incentive to manage earnings based on compensation packages. I like to think of this behavior as “Histogram Management.”

When commodity prices are declining, the easiest way for a mining company to show stable and growing profits is to rapidly increase sales in the wake of declining margins. This strategy of channel stuffing may provide stable earnings figures in the short-term, but it will exacerbate the problem for the entire industry over the long-term.

(Image via Latticework Investing)

Investment lessons:

1) Management often won’t behave in economically rational ways. Therefore, watch out for industries which allow for competition to intensify to the point of mutually ensured destruction.

2) Poorly designed executive compensation can make or break a company/industry.

In other words, don’t give them the rope with which to hang you.

Car Sales Eating into Macy’s Business?

Macy’s CEO said that record U.S. car sales indicate consumers have spent a bigger portion of their budget on bit-ticket items lately.

“At some point in time you’ve got to believe that everybody’s going to have a brand-new car,”…”There’s dollars that are going to be freed up for other categories of spending.” (link)

It makes sense too. Car purchases are highly interest rate sensitive. A majority of new cars are purchased with debt. Today the APR on an auto-loan starts at 3.12%. Meanwhile the APR on a Macy’s credit card is 24.5%. It’s no wonder that sales of goods that can be bought with debt have done well, while cash-based retailers have struggled.

(Image via Interest.com)

Market Developments:

1) Home sales booming on historically low inventory (link)

January home sales reach highest level since February 2007, on the back of the lowest inventory levels on record (circa 1999).

“Home sales rose in January to the highest level since February 2007, a sign that last year’s momentum extended into 2017 despite a limited supply of properties for sale and rising prices.”

“Inventory rose 2.4% at the end of January from the end of December, when supply hit the lowest level since the Realtors association began tracking all types of supply in 1999.

2) Banks Retreat from Apartment Market (link)

Apartment supplies are growing rapidly, as a result, loans are getting more expensive and harder to come by, and rent growth is slowing.

“Swelling supplies of apartment units are prompting big banks to pull back from new projects, forcing developers to scramble for capital.”

“I haven’t seen anything this seismically different since 2008, when credit dried up.”

“fresh supply is beginning to overwhelm demand. More than 378,000 new apartments are expected to be completed in 2017, a 30-year high,”

“Commercial mortgage brokers said they are seeing and uptick in mezzanine loans…(and) a rise in preferred equity, which also come with higher payments than bank loans…”

“Other developers are turning to smaller regional banks, such as Bank of the Ozarks, which can command higher rates,”

3) Corporate Bonds: (link)

All around the world, corporate debt has proved a popular investment class so far this year…

Asia: “Nowhere is the trend more surprising than in Asia, where money has kept flowing into even the riskiest debt. The extra yield, or spread, investors demand for holding both investment-grade and high-yield Asian corporate debt versus risk-free U.S. Treasuries has narrowed since the U.S. election last November and is heading towards its tightest levels since 2008,”

U.S.: “U.S. corporate-bond spreads are at their tightest in two years.”

Europe: “In Europe, investors also have continued to pile into corporate credit in countries like Germany and France, despite uncertainty created by key elections…”

Areas where I see potential problems with corporate debt demand:

1) Naive Extrapolation of past default rates in Asia: “The default rate on high-yield corporate bonds was lower in Asia than in the U.S. last year at 1% versus 3.6%.”

2) “Risk on”: The voracious search for higher yields: “With interest rates globally still low by historical standards, cash-rich investors are on the lookout for higher-yielding assets. Total household wealth is growing more rapidly in Asia than elsewhere globally, up 4.5% in 2016 to $80 trillion,”

4) China developments

Two fascinating highlights on China:

1) “Of the more than 11,000 public-private partnerships that China has announced since 2014-inwhich companies finance, build and manage commercially viable state ventures-88% remain in preliminary stages and none are complete,” (link)

2) “Since coming to power in late 2012, Mr Xi has eroded the consensus-driven, collective-leadership model of his recent predecessors, taking personal charge of the military, the economy and most other levers of power.” (link)

5) Equity Markets

Two fascinating highlights on China:

1) “The declines paused a rally that has sent the index to 19 fresh highs in 2017-its most records in a year since 1999,” (link)

2) “Companies in the S&P 500 traded at about 22 times their past 12 months of earnings as of Wednesday, above their 10-year average of 15.8,”

3) “The S&P 500 has a forward price/earnings ratio of 17.6, the highest multiple since 2004 and above the averages of the past five, 10, 15 and 20 years.“(link)

Organic Farming: The high labor cost problem

U.S. farmers are quite good at conventional farming where emphasis is placed on efficiency. But consumer demand has been shifting towards organic food, which is less efficient to farm, and requires higher labor costs.

(Data source: UC Davis)

Naturally countries with cheap labor will have a competitive advantage on the U.S. Consequently, U.S. farmers have been feeling the pressure from international organic farmers.

“Organic grain is flooding into the U.S., depressing prices and drawing complaints from domestic organic farmers…” (link)

Specifically, the article talks about pressure from Turkish farmers.

“Turkey vaulted ahead to become by far the biggest supplier of organic corn and soybeans to the U.S. last year…(they) shipped to the U.S. 400,000 metric tons of organic corn, nearly quadrupling its prior-year total, while soybean shipments climbed by more than eight times,”

It’s beneficial to dwell on Turkey for a moment because Turkish farming data helps highlight the competitive challenges that U.S. organic farmers face. Firstly, Turkey’s minimum wage is $6,000/year giving them a competitive advantage in labor-intensive crop production. Secondly, the barriers to entry into organic farming are nearly non-existent. From 2002 to 2014 Turkey’s Organic Farming area increased at an annual growth rate of 22.56%.

And from 2005 to 2012, organic production went from 421,934 tons to 1,750,127 tons. (link)

(Data Source: USDA)

It would seem that the shift to organic farming is akin to switching from industrial production lines to hand craftsmanship. The countries with the cheapest labor would naturally have the upper hand.

Note: Additional factors which have added to the pain for U.S. organic farmers include a strong U.S. dollar, and accusations that international organic farmers face weaker regulatory oversight.

Activist Defense Strategy?

Management can sometimes react poorly to unwanted activist investors, leading them to make poor economic/ethical decisions. The following case got me thinking about the possibility that management may revert to unscrupulous methods to increase revenue at a poorly performing unit in order to save it from activist pressures.

ABB Hit by Fraud in South Korea (lInk): “The disclosure (of stolen funds) adds to the pressure on CEO Ulrich Spiesshofer as he tries to fend off Swedish activist shareholder Cevian Capital. ABB in recent weeks announced a string of large orders at its power-grid unit, including a $640 million project to deliver an electricity-transmission link in India, but Cevian has been urging ABB to sell the unit.

From the management’s perspective, it would be easier to defeat activist shareholders if the under-performing unit started “out-performing”. Incentives of this kind may increase the likelihood of unethical revenue enhancement tactics like

Channel stuffing or
Signing sweetheart contracts that are overly generous to clients.

Both of these tactics would make the unit appear more successful just long enough to win over shareholder support and stave off activist shareholders.

I’m not saying that ABB is doing this, but from a standpoint of “incentive-caused bias”, it’s more apt to happen. I’d like to see a study on this topic.

Don’t try to “out-Bezos Bezos”

“We’re not going to out-Bezos Bezos,” Buffett said, in response to a question about the effect of online retail on traditional retailers.

It feels like a lot of retailers are trying to out-Bezos Bezos these days.

Wal-Mart: “The retail behemoth is investing billions to raise U.S. store worker wages, lower prices and expand e-commerce sales to better compete with Amazon.com Inc.” (link)

Target: “Target’s CEO vowed to invest billions of dollars to lower prices and remodel hundreds of stores, an admission that the retailer’s focus on trendy merchandise wasn’t enough to attract shoppers.” (link)

Charlie Munger: Slime Pricing Theory

Great example of pricing theory under pavlovian association and information inefficiencies.

Knead Slime? These Business Girls Can Fix you Up (link)

“Just now, she is puzzling over price theory. She asks 50 cents an ounce-a generous handful-but some friends charge more than twice that. ‘They’re getting more sales and I’m not sure why,’ says the seventh-grader in Issaquah, Wash. ‘My slime is the same quality'”

Charlie Munger: Bias from pavlovian association

“In many cases when you raise the price of the alternative products, it’ll get a larger market share than it would when you make it lower than your competitor’s product. That’s because the bell, a Pavlovian bell — I mean ordinarily there’s a correlation between price and value — then you have an information inefficiency. And so when you raise the price, the sales go up relative to your competitor. That happens again and again and again. It’s a pure Pavlovian phenomenon.” (link)

Social Change becomes Economically Viable

Corporations are rarely agents for social change…even if they pretend like they are. Rather they’re economic agents who weigh supply and demand issues carefully. Demand for a socially beneficial product or service usually needs to hit critical mass (aka “The Tipping Point“) before companies “make that change“. Here are some social changes which have reached critical mass and have become economically viable.

1) Large increases in organic farming (link)

2) Coca-Cola reducing its sugar footprint (link)

3) Tyson eliminating antibiotics (link)

Charlie Munger: The prognosticator of Brazilian graft

I read this article on Brazilian graft and I couldn’t help but be reminded of a talk Charlie Munger gave back in 2003. The scenario he gave for bribing a purchasing agent is almost identical to the problems which were uncovered in Brazil 12 years later.

Charlie Munger:

“Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?…Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent?” (link)

Now here’s what happened in Brazil…

“As part of Operation Car Wash, Brazilian prosecutors have accused executives from Petrobras, the state-run oil company, and some of the nation’s largest construction firms of colluding for more than a decade to inflate the price of contracts, kicking back a portion of the ill-gotten gains to lawmakers and other political officials.”(link)

Caution: A.I. will be programmed to exploit your psychological biases

Watch out for a future where Artificial Intelligence is programmed to exploit your psychological biases better than any human can. Charlie Munger warns heavily about this kind of psychology manipulation:

“Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give.” (link)

It has already started on a small scale:

“Stanford University found a male computerized voice was perceived to be a better teacher of computers, while a female one was preferred for guidance on love and relationships.” (link)

“There’s also the potential subconscious influence. Are we more likely to buy Alexa’s Valentine’s Day gift suggestions if they’re delivered by a female voice? Will a male voice convince us to spring for an expensive leaf blower?”

Teens Use Video Chat to Hang Out (link)

Fascinating insights into teen smartphone use:

“73% of teens have access to a smartphone…Those teens are checking their phones on average more than 80 times a day,”

“Packed schedules, helicopter parenting, and the decline of walkable neighborhoods…The net effect is that teens are spending more time indoors, and les active, than ever.”

“Young people today are sedentary for more than 10 hours a day,”

“Gracie says she’ll turn off the TV and talk to friends if they turn up on Houseparty ‘because that’s just better.’

“who wouldn’t want to be able to check in with their best friends whenever they felt like it?

Quote of the week:

“There were no negative tweets, so that’s a good sign.” – Portfolio Manager in response to Bayer’s CEO meeting with Mr. Trump. (link)

Lewis Screener: Abercrombie & Fitch and Michael Kors

August 24, 2016 / Richard Lewis / Leave a comment

Abercrombie & Fitch (ANF)

featuring Michael Kors (KORS)

Note: This analysis of ANF and KORS leans heavily on my personal stock screener.

Summary

Last weekend I took a look at Abercrombie & Fitch and Michael Kors with the aid of my stock screener.

Given ANF’s poor performance in recent history, I approached it as a case of mean reversion. ANF appears as relatively cheap to its peers, but is not “undervalued”, as defined by my screener. At $22.55 per share, ANF is still within its predicted valuation range of $18.48 to $70.05 per share.

Still, there are a few ways to invest based on the findings. First, you can write put options at a strike price outside of the predicted range. Second, you can simply wait and take advantage of a sudden pull back in the stock price.

KORS meanwhile appears “undervalued”. At a price of $50.78 per share, KORS falls well outside of its predicted range of $61.84 to $108.93 per share. This range is based on KORS’s current ROE of 42.1%.

It’s likely however that the market expects a coming decline in ROE. The market expectations derived from the screener show that KORS’s ROE will decline to somewhere between 14.9% to 31.9%, with a central prediction of 23%. This is a sharp drop from its historical average of 45.2%.

First Screen: Abercrombie & Fitch

To determine if Abercrombie & Fitch (ANF) is currently “undervalued”, I utilized the aid of my personal stock screener. For this screen the pairing multiple of Return on Equity and Price to Book is used. The regression made on ANF and its peers results in a rather high R^2 of 0.92.

Brief explanation: The stock screener uses a simple linear regression to find “Undervalued” stocks. An “Undervalued” stock, as defined by the screener, is any stock that fall two standard errors below the regression line. An “Undervalued” stock in this context is assumed to provide a statistical margin of safety.

As seen in the regression below, ANF falls just slightly above the blue trend line. This indicates that ANF is trading slightly above fair value. But when we consider the inputs used in this screen, it becomes clear that there’s a problem that needs to be addressed.

Note: Any stock that falls outside of the “regression channel” created by the red and blue lines can be considered mis-priced by the market.

Note: The peer companies included in the screen were; related in nature, dividend paying, with a market cap greater than $100 million, and an ROE between 0% and 60%.

ROE Problem

This first screen used the trailing 12 month Return on Equity data from Yahoo Finance. This creates a problem in two ways:

First: Using a single period ROE has the implicit assumption that financial performance of a company is rather consistent from year to year. This assumption may be reasonable for a company like Coca-Colca, but Abercrombie & Fitch has too much fluctuation in its business to make use of a single period ROE.
Second: Using a depressed ROE in the screen will result in a stock appearing as more expensive than it truly is. Given ANF’s recent poor financial performance, it will experience this form of screening bias.

The alternative to using a trailing 12 month figure is to use a historical average which we will look at next.

Mean Reversion

In forecasting the future, there are often two paths one can take; extrapolation of current trends, or mean reversion. As just discussed, the trailing 12 month figure is based on extrapolating the present while a historical average is based on mean reversion.

In his book, “Deep Value”, author Tobias Carlisle explains that the process of extrapolation feels natural to the human mind, but is often misleading. We instinctively want to reward good companies and punish bad ones. But as we carry this out, we become blind to one of the most powerful elements in investing; Mean reversion.

Among Carlisle’s counterintuitive insights includes this quote;

“Stocks with big market price losses and historically declining earnings tend to see their earnings grow faster, and outperform the market.” Meanwhile, “Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market.”

Carlisle explains, “The better bet is the counterintuitive one: deep undervaluation anticipating mean reversion.” Consequently, given Abercrombie’s poor recent history, I thought it appropriate to look at ANF as a mean reversion candidate. This leads me to the second screen.

Second Screen: Abercrombie & Fitch

To account for mean reversion, I made the simple assumption that ANF will mean revert to its 10 year average ROE. Using Morningstar data, I calculated ANF’s 10 year average ROE as 11.9%. Using this new ROE for ANF, I re-ran the original screen.

In this new screen, ANF goes from being mildly overvalued to one of the cheapest stocks. Despite this move, AFN is still not “undervalued”. Thus we cannot reject the hypothesis that the market has mis-priced AFN.

Note: In the following graph notice that ANF has shifted closer to the lower green line, but has not crossed.

Solving for X

Through the use of the stock screener, we have concluded that although ANF may appear relatively cheap, it is not undervalued. Now we move on to answer three important question:

ROE: At what ROE is ANF undervalued?
Price: At what price is ANF undervalued?
Profit: Can we profit from this today?

1. ROE: At what ROE is ANF undervalued?

Given ANF’s current Price to Book Value, I want to know what ROE assumption would make ANF undervalued today. We will call this ROE the “Undervalued ROE”. Within the regression, the “Undervalued ROE” is the lowest expected ROE where ANF drops out of the regression range and becomes undervalued at today’s price.

As seen in the graph below, it’s found that that ANF’s “Undervalued ROE” is 14.1%. Meaning that if we believe ANF will earn an ROE greater than or equal to 14.1% moving forward that we should invest today.

It might be tempting to convince ourselves that ANF can achieve a 14.1% ROE moving forward. Especially after looking at ANF’s ROE from 2004 to 2009. Or after considering that the median ROE of companies in the screen is 14.8%. But there are three reasons to be cautious about expecting a 14.1% ROE moving forward.

First: ANF only averaged an 11.9% ROE for the past ten years.

Second: The last time ANF’s Fiscal Year ROE exceed 14.1% was 2009. It was 15.72%.

Third: High long-term ROE is achieved by businesses that build wide and durable competitive moats, and then rigorously maintain them. In my cursory readings of ANF’s 10k, moat building did not appear high in their priorities for the past 7 years. Rather their plans for the future were largely based in making a swift return to the past. i.e. Their chief focus was restoring gross and operating margins to historical levels through cost cutting.

It’s challenging to expect ANF to enjoy great returns when they haven’t laid the ground work. This reminds me of a quote I read in the WSJ about Yahoo recently, “What Yahoo is going through today is not because of decisions they made three years ago. It’s because of decisions they made 10 years ago.”

2. Price: At what price is ANF undervalued?

Using the earlier mean reversion screen (which assumed an 11.9% ROE), we can find the share price at which ANF is undervalued. This price is $13.68, which is a 39% discount from its close of $22.55 on Friday (08/19/2016).

Before moving on however, I’d actually like to refine this regression a little further. In the “mean reversion screen” conducted earlier, JWN and GPS appeared as Over and Under-valued respectively. This tends to exact a significant influence on the regression. Sometimes it can prove to be quite informative to remove them, which is what I did in the chart below.

Once removed, the predicted PBV of the lower trend line moves from 0.76 to 1.00. This results in an undervalued price of $18.48, or an 18.05% discount from the current share price.

The Price to Book trend data and predicted values for both screens are show below. Notice that the screen gives you the price at which a stock is undervalued (Lower), fairly valued (Trend), and Overvalued (Upper). This feature can assist with both buying and selling decisions.

Note: Not all stocks that appear as under or over-valued within the screen are indeed good or bad investments. There are quantitative and qualitative elements which the screen misses. The screen is generally meant to be an aid which is best used in unison with an investor’s knowledge, insight, and research .

3. Profit: Can we profit from this today?

While ANF’s share price does not provide that statistical margin of safety that we require, there are still a few way to implement these findings today.

Write Put Options: An alternative strategy to invest in ANF is to sell put options with an exercise price near or below the “undervalued” price.

For example, one could sell a January 2017 put option with a $19 strike price and take in a $1.70 premium. Then, if you get put the shares at expiration, you’d effectively be buying them for $17.30. Well below the undervalued price of $18.48 per share.

Wait: Understanding the range where ANF is undervalued, we can opportunistically use this information if stock price should decline. But periodic updating of the screen results will be necessary.

Recap: Abercrombie & Fitch

The regression analysis found that ANF is not currently “undervalued” at its Friday close price of $22.55. Rather you may say it becomes undervalued somewhere below 18.48. But that’s ok. It’s still possible to wait and buy ANF if it becomes undervalued. Additionally, it is possible to write uncovered put options with a strike near or below the undervalued price and benefit accordingly.

Michael Kors

Note that when I ran the ANF screen earlier, I excluded all non-dividend paying stocks. This meant that stocks like Michael Kors (KORS) did not appear. So after I finished, I doubled back and ran another screen to include these non-dividend paying stocks.

The result: Michael Kors appears as undervalued. In the screen below, KORS appears significantly below the lower green trend line. This means that we can reject the hypothesis that KORS is fairly valued given a 42.09% ROE.

The lowest valuation that is justified by the regression is $61.84 per share, which is an 18% discount from its current share price of $50.78. In fact, the regression predicts a valuation range for KORS of $61.84-$108.93.

These predicted values are contingent upon KORS’s future returns on equity resembling its past. The market on the other hand, likely believes the future will be worse. Exactly how much worse is what I want to know. For that, we can go back to the screen.

Earlier, we found the “Undervalued ROE” that would make ANF fall outside of the “regression channel”. This time, we want to find the range of ROE’s that would make KORS fall within the “regression channel”.

Doing this we find the that the market expects a future ROE in the range of 14.9% to 31.9%, as shown above. This is in contrast to KORS’ historical ROE of 45.2% and trailing 12 months ROE of 42.1%. This implies that if an investor expects Michael Kors’s future ROE to resemble the past, or be higher than 31.9%, then KORS offers considerable value at today’s price of $50.78 per share.

Yahoo Opportunity: The Market Thinks Yahoo Is Insane

November 12, 2015 / Richard Lewis / Leave a comment

“Sometimes I use to wonder if I was nuts.” – Warren Buffett

If the market is efficient, then Yahoo must be completely nuts. That’s the only way to rectify Yahoo’s (NASDAQ:YHOO) current share price. Given where Yahoo trades, the market believes that there is a ZERO PERCENT probability that Yahoo will successfully spinoff its Alibaba (NYSE:BABA) shares into Aabaco Holdings. To put this into context, a successful tax-efficient spinoff of Aabaco is worth upwards of $9 per share. But the market has placed exactly zero probability and therefore zero dollars of value to this outcome. In fact, to hold such a strong assertion, the market must think that Yahoo’s Aabaco hopes are merely hallucinations and nothing more. In other words, Yahoo is certifiably insane.

Yahoo Certified Insane

Such a strong conviction by the market must be supported by equally powerful evidence. If it turns out that the market has mis-weighed the facts, then a profitable opportunity likely exists.

This article will examine the sanity of Yahoo and the resulting investment opportunity. There are three stages to this assessment:

A Yahoo Sum of Parts Analysis: A sum of parts analysis will reveal how much value the market places on the probability of a tax-efficient spinoff, and the value of Yahoo’s core business.
Analyzing the Evidence: We will contemplate the evidence required to be 100% certain and then juxtapose that against the evidence which the market has at its disposal to form an opinion.
Investment Opportunity: Given the article’s findings, we will examine the investment potential of Yahoo and the best way to maximize value.

Sum of Parts Analysis:

Given that Yahoo is primarily composed of actively traded securities and other highly liquid assets, a sum of parts analysis is a highly useful tool for examining Yahoo’s market valuation. By stripping out the after-tax stakes in Alibaba and Yahoo Japan as well as Yahoo’s net debt, we are left with $585 million, or $0.62 per share.

This remainder of $585 million, or $0.62 per share, is the total value that the market has assigned towards two assets:

Yahoo’s core operating business
The value of a tax-efficient spinoff of Aabaco

To determine how much of those 62 cents are attributable to the Core business and how much to the tax-efficient spinoff, let’s estimate the value of Yahoo’s core business.

The general consensus among industry analysts is that Yahoo’s core business should trade between 3 to 5 times EBITDA. Using the middle ground of 4x EBITDA, that gives us a value of $3,440 million, or $3.64 per share. At that valuation, we’d have an 83% margin of safety.

Valuation Analysis

If you assume that the entire residual value of $0.62/share is attributable to Yahoo’s core operating business, that means it’s trading at only 0.68x its 2016 EBITDA estimate. To put that into perspective, Verizon recently acquired AOL for 8x EBITDA.

With such a generous margin of safety when looking at Yahoo’s core business, we can be assured that the market is assigning no value to a successful spinoff of Aabaco. Now that we’ve verified that the market thinks that Yahoo’s management, board of directors, and tax lawyers are all insane for going ahead with the spinoff, we can analyze the evidence and issue a second opinion.

Analyzing the Evidence:

As stated earlier, in order to make such a bold assertion about the impossibility of a successful Aabaco spinoff, the market needs to have equally compelling evidence. To assess the market’s opinion let’s run a thought experiment. Let’s imagine what evidence we’d actually need in order to arrive at a zero percent probability and then juxtapose that against the evidence which we’ve actually seen.

There are three major elements which we will examine in this manner. They are an IRS Private Letter Ruling, any IRS Guidance, and the professional consensus. Let’s take a look.

#1: IRS Private Letter Ruling regarding tax-free status of Aabaco spinoff.

Evidence we’d need: The IRS would have issued a Private Letter Ruling denying tax-free status to the Aabaco spinoff.

Evidence we’ve actually seen: The IRS declined to give a Private Letter Ruling on Yahoo’s proposed tax-free spinoff of Alibaba. Although the IRS did not indicate whether it was ruling against the request. As described by Tony Nitti, “No, it’s not dead…It just means that the IRS didn’t have the decency to tell Yahoo whether it’s dead or not. This means if Yahoo wants, it can still move forward with the transaction, but with no assurances that the spinoff will be tax free….It appears they have faith in their tax attorneys, and will move forward with the spin.”

#2: IRS Guidance.

Evidence we’d need: The IRS would have issued new guidance thereby eliminating the possibility for tax-efficient spinoffs.

Evidence we’ve actually seen: The IRS has not issued new guidance to date, but it did formally announce on July 31, 2015 that it was studying potential new administrative guidance with respect to spinoffs.

#3: Professional Consensus:

Evidence we’d need: Tax Lawyers & Analysts would be in consensus that the tax-efficient spinoff will fail.

Evidence we’ve actually seen: Tax Lawyers & Analysts are generally more positive than not that the tax-efficient spinoff will go through successfully. Two such examples:

FBR said its latest comment on Yahoo assumes that the company will succeed in the push to spinoff the stake in Alibaba Group Holdings Ltd in a tax-efficient manner.
“I believe the spinoff will proceed as planned and, in the final analysis, will be found to be tax-free,” said Robert Willens, a New York-based tax consultant.

In all three cases, it is impossible to arrive at a conclusion that approaches absolute certainty. Instead the current set of public information requires us to make a series of subjective judgments as to the likelihood of the IRS’s action.

The acid test for insanity is to either be hallucinating (i.e. perceiving something that’s not there) or delusional (i.e. false beliefs). As demonstrated above the IRS has made no definitive actions to close the doors on Yahoo. Meanwhile the general opinion of Yahoo’s legal counsel has a positive outlook towards the spinoff, as do industry analysts and tax lawyers on the whole. While significant uncertainty exists, Yahoo is certainly not hallucinating about the chance of a successful spinoff.

For that reason, Yahoo can officially be declared “Not Insane”.

Homer Simpson "Not Insane"

(Source: The Simpsons)

As can be seen with Yahoo, the market often has a hard time distinguishing between insanity and uncertainty. From time to time Mr. Market misdiagnoses a stock with great uncertainty as being “insane”. Consequently he sometimes offers to sell these stocks at insane prices. As Warren Buffett has said, “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

Investment Opportunity:

Value of the Spinoff:

How much is a successful spinoff worth? Even if the Aabaco spinoff is successful, it will invariably trade at a discount to Alibaba shares. To get an estimate for the discount assigned to the Aabaco shares, it’s helpful to calculate the Accrual Equivalent Tax-Rate (‘AET’) under a scenario where Yahoo holds onto their Alibaba shares for 50 years before selling. Assuming moderately optimistic returns, Yahoo’s AET would fall to around 10%.

As a result, we will assume that the spinoff will trade at a price that accounts for a 10% Accrual Equivalent Tax-Rate. At a 10% AET, shareholders would realize $8.63 of value in the event of a successful spinoff.

Return Profile:

A successful spinoff would be worth around $8.62 per share, and the intrinsic value of the core operating business is worth approximately $3.64 per share. These two assets are worth upwards of $12.24 per share, instead they are currently trading for $0.62.

There are two ways to gain exposure to these undervalued assets.

First, you can simply buy the Yahoo’s common stock, whereby you have a potential upside of 37% to its current share price. The risk under this scenario is that you retain significant exposure to Alibaba. Although for investors bullish on Alibaba that may be an attractive feature.

The second option is to invest in the “stub” stock of Yahoo. This involves buying Yahoo and subsequently shorting out the after-tax value in Alibaba. (This strategy is described further in the article Yahoo’s Tax Edge.) Investing in the “stub” stock increases your potential upside to 97% by both increasing your exposure to Yahoo’s undervalued core business as well as any future tax avoidance. At the same time, you eliminate most of your exposure to fluctuations in Alibaba’s stock price.

The scenario above examined the best case outcome. Below you can observe the probability weighted returns under five different likelihoods. It is important to note that there is an attractive return available at every probability weighted return. This demonstrates just how attractively priced Yahoo’s shares are at the moment.

Final Look:

This article does not attempt to make a prediction about the probability of a successful spinoff. Such a prediction is outside of the circle of competence of this author. It does help however to know that no matter what the outcome, Yahoo is priced at such a level where the downside is limited and the upside is substantial. In the words of Mohnish Pabrai, this is an example of an investment where “Heads I win; tails, I don’t lose much.”

Risks to the Investment:

It’s important to acknowledge some risks which may be inherent within Yahoo:

1. If there’s a dispute over the tax status of the spinoff, there’s a chance that Yahoo could end up in a drawn out court battle with the IRS.

2. It’s possible that the market is discounting the cash held by Yahoo by a significant amount. The market may be using the assumption that any cash not assigned for share buy backs is as good as gone. Considering Marissa Mayer’s poor investment record since becoming CEO, it’s hard to argue against such a scenario.

Since becoming CEO, Marissa Mayer has spent over $5 billion on acquisitions and research and development. Today Yahoo’s core business is trading at $585 million.

3. A company is only worth as much as the present value of all the cash flows you expect to receive. By assigning a value of $585 million to Yahoo, the market may be indicating that they expect to receive very few cash flows in the future. They may be justifiably concerned if Marissa Mayer continues to invest operating cash flows without positive results.