Saturday, March 8, 2014

A Different Approach for a Different Objective.

What if it is the stock not the portfolio?

In a previous posting entitled “The Widows’ and Orphans’ Portfolio and US Banks” the composition and objectives of the portfolio were used to identify a particular reinvestment plan for 2014.  However, the portfolio objectives outlined in the article include the diversification of risk to the capital (management of the size of the holdings) and diversification of the income streams they generate through dividends.  They are not the only potential portfolio objectives.

An equally acceptable alternative objective would be growth in the total portfolio based on combined capital gains and dividends.  That approach is particularly appropriate for an investor in the accumulation phase.  Individuals in the accumulation phase are usually younger and may be willing to take a little more concentration risk.  This second approach necessitates more attention to the price of individual stocks and the timing of individual stock purchases.  That will be the topic of this posting.

The portfolio holds a significant position in Verizon (VZ).  While the dividend represents an appropriate portion of the portfolio, the amount of Verizon stock held in the portfolio could be increased without undermining the portfolio’s design.  An investor who is just building the portfolio might want to begin accumulating Verizon now.  The same might be true of any investor with different portfolio weights. 

The portfolio’s design is for all the stocks to be potential long-term holdings.  However, as has been discussed in this blog, the market will occasionally provide an investor with an opportunity to purchase long-term holdings at a discount.  The first thing is to determine whether there is any reason to believe that such an opportunity currently exists in Verizon stock.

After the financial crisis, there was a deluge of books and articles about the investment mistakes made by many of the larger money managers.  Back in April of 2010, The Hedged Economist included a number of postings analyzing some of those mistakes (e.g., “Sometimes Wall Street provides more entertainment than Hollywood: PART1 the winners” and “PART 2 the losers”). Looking at these mistakes was an extremely useful exercise.  It is always more fun to try to learn from other people's mistakes instead of making them yourself.

One thing that was particularly interesting was how often investors were burned because they failed to analyze the motives of their counterparty.  (If they were buying, they forgot to look at why their counterparty was selling, or vice versa).  An analysis of counterparties’ motives has become a frequent and often very useful supplement to the traditional financial and technical analysis.

In the case of Verizon, such an analysis is possible.  One knows that the Vodafone acquisition resulted in the distribution of Verizon shares into the hands of a number of individuals and financial institutions that never explicitly chose to purchase the shares.  More importantly, some of the institutional investors may be operating under portfolio guidelines or institutional charters that require them not to own foreign stocks.  Consequently, it is reasonable to assume that there are sellers of the shares who are not expressing a judgment about the future of the company.  The phenomenon described is sometimes referred to as “post-acquisition blowback.”  If that line of reasoning is correct, the recent decline in Verizon's stock is an opportunity to purchase at a discount.

There is a second reason to believe that a purchase now is appropriate for the long-term investor.  This blog often makes reference to a posting entitled “Wall Street doesn’t run the world.”   The reason is that the posting makes the important point that Wall Street is largely composed of investors with very short-run horizons.  It is not at all difficult for an investor to take advantage of any difference between his or her investment horizon and the typical investment horizon of Wall Street.

It is easy to see how that may apply to Verizon.  With its earnings release, Verizon ruled out stock buybacks for at least two or three years as it aims to slash that debt.  Impatient investors do not like that sort of behavior.  They had bid up Verizon stock based upon the increased earnings expected from their purchase of Vodafone.  Verizon's announcement of what it was going to do with those earnings was accompanied by selling of the stock.

Wall Street's time horizon makes that response totally understandable.  If Verizon used the increased earnings to purchase shares that they issued in connection with the acquisition, it would increase earnings per share.  The increased earnings per share would occur at the time the purchases were made.  It is a reasonable strategy, but not a long-run strategy.

If Verizon purchased back shares it would be influencing per share earnings before interest, taxes and amortization.  However, the interest paid per share would increase.  By reducing debt instead, Verizon does not directly influence earnings before interest, taxes and amortization per share.  Rather, by paying down debt, it decreases the interest expense.  Thus, earnings after interest, taxes and amortization will increase “other things being equal.” Ultimately, in the long run, it is earnings after expenses that the investor should be seeking.  Consequently, foregoing the short-run increase in earnings before interest, taxes and amortization should result in a greater return after interest, taxes and amortization, but it may be a slower process.

Thus, there are at least two reasons to think that Verizon stock may temporarily represent an opportunity: post-acquisition blowback and Wall Street impatience.  The next step in determining whether the stock represents such an opportunity is traditional financial analysis.  Using traditional measures, there is no compelling case for adding Verizon right now.  It is worth noting, however, that acquisitions sometimes create a situation where traditional analysis looks ambiguous.  As already mentioned, Verizon's stock has underperformed.  The Hedged Economist is not an expert in technical analysis.  However, the underperformance could represent an opportunity.  It is an opportunity that could continue to exist or even become more inviting.

Stepping back and analyzing the business, there are both pros and cons.  Verizon operates in increasingly competitive markets.  That is true of the cell phone business and FiOS.  However, Verizon has a long history of being able to flourish in competitive markets.  In addition, the reason the markets are competitive is that they are attractive and growing.  It has been many years since Verizon made any major strategic mistakes in approaching the markets, although future mistakes are always possible.  From a strategic perspective, Verizon made a couple of very forward-looking decisions a number of years ago.  If Verizon can continue to anticipate consumer and technical trends, its business should prosper.

A reasonable conclusion would be that the current period of underperformance represents an opportunity to accumulate the stock.  However, that conclusion is highly dependent upon the investor’s timeframe.  There is no need to do it all at once, and it may best be done by selling cash-covered puts at lower strike prices.

The situation at Exxon (XOM) is, in some respects, analogous to the impact of Verizon's statement in connection with its earnings release.  Exxon’s problem does not relate to debt, but like Verizon’s, it involves details about the company’s use of capital.  Exxon announced that it would be lowering its capital expenditures.   Since Exxon has not been growing reserves, this decision has caused concern, and it resulted in a selloff of the stock.

Given that Exxon is one of the largest companies in America, the decision to reduce capital expenditures received considerable attention.  For a summary of the details and illustrations of the attention it has garnered, see “Are ExxonMobil's Reduced Capital Expenditures Cause for Concern?” or “Is Exxon Mobil Heading for an Inflection Point in 2014?”  Those two articles provide excellent background on the issue while “Exxon Performance, Spending Cuts Rattle Investors' Nerves” is an excellent description of why investors were concerned. 

The bottom line is that the cut in capital expenditures was very minor when compared to capital expenditures over a long-term period of time.  Interestingly enough, the increased capital expenditures in past years brought on an equal number of concerns among investors and selling pressure.  The long-term investor might be very tempted to dismiss both as simply management decisions made in the course of doing business in an area that requires large, long-term investments.  That, in fact, seems like a very reasonable conclusion at this point.  Thus, the current selloff presents an opportunity.

However, a recent article on Seeking Alpha entitled “Exxon Mobil Needs A Big Dividend Hike This Year” touched off a stream of very interesting comments.  As many of the comments on this thread make clear, if Exxon does not raise its dividend, there are large numbers of investors who may sell and present an investor with an even better opportunity to purchase the stock. That could be a wonderful thing. Imagine being on the same side of the market as one of the most capitalized companies in the world, as well as with investors like Warren Buffett.

Although the stocks of Verizon and Exxon presented opportunities, those opportunities should be viewed in the context of the total portfolio and the investors’ objectives for the portfolio.  If the issue were simply to pick the stock that will appreciate the most over the next six months to a year, neither company would probably be the winning candidate.  As discussed in “What is to be learned for 2014 planning?” one would probably want to focus on PPG.  However, current developments in both companies’ stocks present opportunities to those focused on constructing a long-term portfolio.

1 comment:

  1. Verizon communication seems to lie under positive side somewhere and an explain the worth of having a portfolio quite beautifully.