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Posts Tagged ‘stock market’

Why is a value investor writing about an unprofitable internet company? Because value investing is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way to know for sure. Let’s take apart my argument piece by piece, and see if any of my assumptions are unreasonable.

First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash consumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.

That’s not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem – possibly a very big problem. So, which scenario is more likely?

Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. Overstock’s unprofitability is the result of its selling, general, and administrative expenses (SG&A) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex has been 5.6% of sales. That number is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral over the next five years is not overly optimistic.

Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock’s revenue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.

Also, all that spending on advertising is increasing consumers’ awareness of Overstock. A review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. While it is a long, long way from the Amazons, Yahoos, and eBays of the world (and will never reach those heights) Overstock is becoming a well known internet destination. This fact was most clearly evident in the weeks leading up to Christmas. Shoppers who visited Overstock during the holiday season obviously know it exists, and may very well return at some other point in the year. Analysts are predicting very high growth rates for Overstock; however, they are also recommending you sell the stock. I don’t put any weight in their estimates. But, for the other reasons given, I believe the assumption that Overstock will grow sales at 15% a year for the next five years is not unreasonable.

Third Assumption: Six to ten years from today, Overstock will have a free cash flow margin of 3%. Ten years from today, Overstock’s free cash flow margin will rise to 4% and remain at that level. Now, of all the assumptions I’ve made, this one is the most questionable. Sure, Amazon has that kind of free cash flow margin, but Overstock isn’t Amazon, and it never will be Amazon. Overstock’s gross margins are less than Amazon’s. In fact, Overstock’s gross margins are less than Wal – Mart’s. However, Overstock’s fixed costs will eat up a much smaller portion of its sales than is the case over at Wal – Mart.

If you compare Overstock to other online retailers, you will see that if Overstock does experience strong sales growth, a 3% free cash flow margin six years from now is not unreasonable. I assumed Overstock’s sustainable free cash flow margin will be 4%. There’s a case to be made that 4% is too high. I won’t make that case, because I don’t believe in it. Remember, that 4% number comes ten years out. That gives Overstock plenty of time to grow sales and thus reduce SG&A as a percentage of sales.

Fourth Assumption: Six to ten years from today, Overstock will be growing sales by 12% a year; eleven to fifteen years from today, Overstock will be growing sales by 8% a year; thereafter, Overstock will grow sales by 4% a year. Let’s see what this really means. According to these assumptions, Overstock’s sales will be as follows:

Today: $707 million

2011: $1.59 billion

2016: $2.71 billion

2021: $3.83 billion

2026: $4.66 billion

2031: $5.67 billion

2036: $6.90 billion
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If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for but a moment, you will recognize how truly foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn’t determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is attractive. Likewise, you needn’t determine whether “the market” is undervalued or overvalued; you need only determine that a particular stock is undervalued. If you’re convinced it is, buy it – the market be damned!
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It’s been a wild and wooly couple of weeks on the international stock markets. But is the recent slide grinding to a halt…or just taking a breather before tumbling some more? And more importantly, what does it mean to astute penny stock investors?

Wall Street recently stumbled to its worst week of the year, and global stock markets fell dramatically on concerns about rising interest rates and slowing growth. After rising almost 9% in the first four months of the year, the Dow Jones industrial average has fallen about 6.5% from a six-year high, reached May 10, 2006.

Stocks have been ailing because penny stock investors fear the Fed could be so focused on inflation that it ignores signs of an economic slowdown, raises interest rates too high and sends the economy into a recession.

Global stock markets were sent reeling last week after golden-tongued U.S. Federal Reserve Chairman, Ben Bernanke shocked penny stock investors in saying the Fed will continue raising interest rates to keep inflation in check.

And that decision will have a direct impact on the penny stock market. Higher interest rates hurt penny stock prices because investors believe it will curb economic growth and corporate profits.

But why is inflation heating up? Higher energy costs. Traders and penny stock investors are also worried that with the hurricane season officially under way, Gulf Coast refineries and oil production sites could be damaged again this summer and fall.

And higher interest rates have the ability to affect the entire economy. Finance charges on credit cards will rise. So too will rates on mortgages and home equity loans, putting additional pressure on homebuyers and a softening housing market. Ultimately, it will cost more to borrow for expansion. Read the rest of this entry »

A Winning Approach to Trading in the Stock Market

Many traders lose simply out of ignorance. They base their trades on hunches, news, or tips from friends, and do not define specific risk and profit objectives before placing trades.

Others have the merit of educating themselves but fall victims of their emotions. They hold on to losing positions hoping they will turn into winners and sell winners by fear of losing a small gain. They overtrade to fulfill a need for action or by fear of missing out.

The consistent winners follow a winning approach:

• They have a strategy to enter and exit trades
• They use good money management
• They take consistent actions, they follow a trading plan
• They keep good records so they can review their actions
• They avoid overtrading
• They have a winning attitude

A strategy to enter and exit trades

You need to a strategy to put the odds in your favor for each trade you take. Your strategy should be as objective as possible and include the following elements:

• Entry: conditions required before you can enter a trade – may include technical analysis, fundamental analysis, or both.

• Initial stop loss: price at which you will close the entire position if it does not go in your favor. The risk per share is the difference between the entry price and the initial stop.

• Initial price objective: price at which you will take some or all profits if the trade goes in your favor.

• Trade management: set of rules that dictates your actions while a trade is opened. It may include trailing stops, closing position, etc…

For every action you take, the reason should be clearly described in your strategy.

Money management rules to keep losses small

The goal of money management is to ensure your survival by avoiding risks that could take you out of business. Your money management rules should include the following:

• Maximum amount at risk for each trade. The different between your entry price and your initial stop loss is your risk per share. Your maximum amount at risk for each trade determines the share size.

• Maximum amount at risk for all your opened positions.

• Maximum daily and weekly amount lost before you stop trading – avoid trying to trade your way out of a hole after a loosing streaks.

During your learning phase, your goal should be to survive, not to make money. Start with low limits and raise them as you become a consistent winner otherwise you will simply go broke faster.

Good record keeping

Although the process of gaining experience cannot be rushed, it can be made much more efficient by keeping good records of your actions. Good records will allow you to:

• Review your actions at the end of each day to make sure you followed you strategy, not your emotions.

• Learn from your losses – they cost you money, make sure you get the education in return.

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