Post of the Day
August 19, 1999
Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light.
[Edited for length]
Anyone still with me? Here goes:
When I wrote the first volume, I didn't really understand LTBH, but I think it's coming into focus. First a major digression so that I can be sure I really do understand since this understanding is central to the end point of my quest. Again this prose may sound like teaching, but it's not. I'm no expert. Just insert "right?" after each sentence as you read and you'll be reading it the right way.
The Major Digression
There are two systems at work in the stock market: 1) business and profits and 2) pricing and valuation. While we expect the two to be related, they don't have to be. Speculation is the force that can smash the bond.
As there are two systems, there are two sets of "fundamentals". The price world has its' fundamentals: P/E, P/Sales, PEG, etc. Since these ratios involve "price," they are influenced by speculation. They can change independent of current business realities. These are the fundamentals most dear to the market-timer and the technical trader. This is, of course, a simplification, but it's at least true that price dominates in these strategies.
Likewise, the business world has it's fundamentals: Sales growth, earnings growth, margins, market share, market penetration, debt ratios, etc. These are independent of speculation and always constrained by business realities (short of accounting and debt structure hocus pocus, but even I don't want to get that far in the hole�). I believe I'm beginning to understand that this is the domain of the LTBH investor. Again, a simplification, but I think accurate in terms of emphasis.
(It seems to me that in this context, Value investors bridge the gap since they focus on the relationship between the two dimensions, price and business, but anyway�)
Some things don't depend on strategy. Everyone wants to buy low and sell high, to get from price A to price Z, and to do it in a reasonable time-frame. By "reasonable" I mean a time-frame that allows us to easily beat the rates available from safer investments. That everyone agrees on. In addition, we all should consider the most critical time question � when will I need this money? � before we buy. I think all sensible investors agree on this much.
Now, here's where the differences arise. The more an investing strategy overlaps the price dimension, the more focus there is on the path from A to Z. The more an investing strategy leans towards the business dimension, the more interest in the total distance from A to Z. I'm not saying that strategies more towards the price dimension are satisfied with less price growth, just that they are more likely to take profits when the returns are good, regardless of how far the price is from its final destination, Z.
So, paraphrasing the LTBH investor: Based on an evaluation of the business, I believe that the "fair" price will be around $500/share (not adjusted for splits) within 10 years. So I'm buying it today, and I don't plan to look at the price for 10 years. I'll check the business fundamentals to insure my fair price projection still makes sense, but I'm confident that provided the business stays on track that, in 10 years, the numbers will be there. Sure there will be a ton of price volatility in between, but stocks always grow in the long term, so I won't sweat it. I won't try to figure out Greenspan and interest rates, bull or bear markets, the impact of Y2K, etc. in the meantime, except to the extent that these things disproportionately impact the particular business or industry I have invested in. No thanks, I prefer playing with my kids.
On the other hand, what happens "in the meantime" is precisely where the market timer and the technical trader attempt to make their money, by beating other speculators at their own game. By playing the jagged path from A to Z, not the smoothed one. This is a market game; the LTBH investor's is a business game.
Starting Back Towards The Point
So what's all this got to do with the first two posts. If I'm on track, plenty.
First, one of my original criticisms of LTBH AMTD holders was their constant reference to "fundamentals". I now realize that while I was focused on price fundamentals (PEG), they may have been focusing on business fundamentals. There's a big difference, I've learned. In fact my little simulation exercise proved to me that price is the wrong number on which to base my AMTD profit taking strategy. There's just no way to set up a price-dominant strategy that makes any sense in such a volatile, emerging growth industry.
Second, it means that if I lean towards investing strategies on the LTBH side, which my original post pre-supposed, my profit taking strategy should be based less on the price path from A to Z and more on how close the price has gotten to Z. In other words, I don't panic and sell when the stock is overvalued by today's terms, only if it is overvalued relative to what the business fundamentals tell me to expect in 10 years.
Let's say an investor towards the LTBH end of the spectrum looks at the discount broker market growth, AMTD's share in this market, account and sales growth expectations, international prospects, etc and predicts a fair value for AMTD of $250/share (unadjusted for splits) in 10 years. (A=$25, Z=$250, Annual rate of return conveniently chosen by me to be roughly 25%).
Now, let's say that 6 months later, AMTD's price goes on another fabulous run, up to, say, $175 in three weeks. I suppose a LTBH purist would say, "That's great. We're on our way. Now where did I leave that Sesame Street CD-ROM..."
And a market timing purist would say - as I did in my initial post - "SELL!!!! Are you crazy?"
I'd like to propose a middle strategy, closer to the LTBH side, but with some room for profit taking. Have you noticed? I'm closing in on the original issue!
An LTBH Investor Develops a Strategy for Taking Profits on AMTD
The first thing I need to do is to set my sights on price Z for AMTD. I used 10 years in my thinking above, but I think I'll switch to 5 years for my strategy, since in the on-line broker industry, the next five years will be a lifetime.
Of course picking Z is the part of investing that nobody ever gets right, but it's made easier in this context by the fact that I'm a LTBH investor who's very high on this company's business model. So I'm not looking at a sensible, consensus price, but where I hope it will be if everything false into place � a "best possible" scenario." After all, even a LTBH investor expects some bets to pan out and others not to, and if this is going to be one that pans out, I don't want to cut off my high side by taking profits at a "tempered" estimate of price Z!
So, I'll take a shot at picking price Z. Won't be the most scientific, but I can't get anywhere without Z in my new world-view, so here goes. Let's start with revenue data, for the last seven quarters. I've included only Trading Revenue and Interest Earned on Assets in these figures, since these are the only reliable streams of income in the current AMTD business model:
Q end Revenue(mill) Growth Dec-97 $28.9 Mar-98 $34.2 18% Jun-98 $42.9 25% Sep-98 $46.3 8% Dec-98 $59.7 29% Mar-99 $71.6 20% Jun-99 $87.3 22%Since I'm thinking best case here, let's assume that AMTD can maintain a 5 year quarterly revenue growth rate of 20% (107% annually):
87.3 x (1.2)^20 = 3,346.9
So I'm hoping for 3.3 x 4 = 13.2 billion dollars in annual revenue at the end of this time period. If I change to a 15% quarterly revenue growth expectation, this whopping number gets sawed down to 5.7 billion and if I change to 25% it goes up to over 30 billion. No wonder nobody can figure out what these stocks are worth!!!! Anyway, let's stick with 13.2 billion.
Now, in 5 years AMTD should be closer to a "mature" broker, so let's see what a mature broker currently cuts in terms of profit margins. Last quarter, Merrill Lynch had 5.44 billion in total revenue and earned 0.67 billion, for a profit margin of about 12% (the quarter before this shows similar numbers). Still thinking best case, let's say AMTD can do 20% by virtue of its radically lower overhead. This gives us 20% x 13 billion = 2.6 billion in annual profits for our little discount broker in 5 years.
On to price Z. There are currently 174 million shares of AMTD outstanding, so, allowing for a little future share creation, we're talking about roughly 2.6/0.2 =$13 as a best case earnings per share figure. This works out to 5 year annual growth rate of about 144% in EPS vs the most current AMTD figure ($0.15/share). Wow! I'm tempted to scale back, especially in light of today's news, but I'll stick to the plan.
So far, we've managed to stay in the business domain, but even the LTBH investor has to talk price domain eventually in order to pick a Z. I'll do this by speculating on a "reasonable" P/E. Now since the LTBH model doesn't want to assume too much speculation in it's "fair value assessment", and a lot of the speculation will have run its course in 5 years, I'll go with a P/E target of 30 for AMTD (Merrill Lynch is currently around 22). Given this P/E, I end up with a best case, "fair" price estimate of 30 x 13 = $390/share. I have arrived at my Z!
OK, so I think I have my "lunatic" price. If AMTD hits $390 within 5 years time, anyone who doesn't sell is a lunatic, says me. This would be the pure LTBH investors profit taking point. But I'd like to add a little of the ol' A to Z into this, so let's look at this on a year by year basis.
Going from $25 (rough current price) to $390 in 5 years means the average growth rate for the share price will be 73%. Let's assume the smooth path from A to Z:
'99 $ 25 '00 $ 43 '01 $ 75 '02 $129 '03 $224 '04 $387The Strategy
Given this table, I think I'll adopt the following "LTBH Investor's Profit Taking Rule for AMTD." If the price gets 24 months or more ahead of this smoothed "lunatic" price curve, I'll sell and start over with my initial investment. In other words, if the price hits $75 in the next year, I sell. $129 the following year, I sell, etc. Anyone with me?
Somewhere along the way, I'll have to re-evaluate and come up with an updated "lunatic curve," but my adoption of an LTBH strategy should leave me plenty of time for the kids "in the meantime."