Adding Verizon (NYSE:VZ)

Six months ago, I threatened to switch to AT&T if  Verizon did not offer me lower rates. The customer service representative politely told me to kick rocks. When the customer service representative would not budge, I pulled the manager card. When the manager didn’t budge I resigned myself to expensive cell phone bills and hung up. I should have invested immediately. That is serious pricing power.

I am adding a position in Verizon Wireless (NYSE:VZ). There has been a lot of publicity about Berkshire Hathaway’s recent stake. I am honestly a bit ashamed to drag along after Buffett and Paulson. I was confident that I could find a better investment in the space, and Bezeq came pretty close. Ultimately, my telecom investment was about safety. VZ’s numbers are fantastic and reassuringly consistent. Cell phones today are as necessary to the average Joe as water or electricity. This is essentially a utility stock, which pays a dividend of 4.26% currently, and which consistently generates a high free cash flow yield of over 7%. VZ’s gross margin hovers around 50%, with an operating margin that stays in the high teens. The current Price/Free Cash Flow multiple is 8.02, well below it’s main rival AT&T, which is trading at a P/FCF of 14.55.

By altering its capital structure, Verizon takes on more debt at historically low rates, and sheds itself of a significant drain to dividends. Assuming that Verizon can continue to generate strong Operating Cash Flow, this act should increase Free Cash Flow Return on Invested Capital from a historical range of 8-11% to over 15%! If Verizon stays true to its history shareholders will see dividend hikes in the future. This is a classic value investor play.

I also looked hard at Vodafone (NASDAQ:VOD), but opted for the proven track record at Verizon. I think VOD has fantastic potential in the emerging markets, but I am worried about regulation in Europe. VOD also has a spottier track record of returning cash to shareholders. Lately, management has been quite generous with dividends, but I wonder if they can keep it up. I may invest in VOD in the future, but prefer to keep my options open for now. Price/Free Cash Flow appears low at 5.26, but whether management will invest or distribute cash wisely is another question altogether. Historically management hasn’t used free cash flow effectively.

My other prospect was Bezeq, the Israeli Telecommunications Company (TLV:BEZQ). The firm has declining sales volume in a fleshed out market. On the positive side, they pay a very attractive 7.9 % dividend after foreign residence tax, with a payout ratio of 100%. Bezeq appears to have a headlock on the local communications market (cable, internet, and cell phones) despite government-mandated market reforms. P/FCF here is also attractive at 6.55. What scares me away from Bezeq is the possibility of currency fluctuations. The whole point of a Telecom investment to me was to find a safe place to park some cash. VOD could work because of its international diversification. Verizon works because I live in the U.S.

It also helps that Verizon and AT&T represent a duopoly. Some investors have been skittish to invest because of the debt load. I would ask them to try going a day without their cell phone. Better yet, try to negotiate a discount.

Advertisements

Is the Stock Market Over-Valued? Yes. Should you be worried? Not if you’re under 40.

Pundits have been arguing 3 very disparate views on the market. General consensus is that this year’s stock market returns will not equal last year’s 30% rally. The divergent perspectives are outlined below.

Will skepticism keep a healthy check on bull market overvaluation? This would seem to be a fair point. Bubbles only happen when most investors forget about risk. You cannot argue that we are in a bubble if everyone is yammering about the danger.

Is Buffett right? Are markets back to a fair valuation after years of cheap investment opportunities? Possibly. No one can argue that P/Es are cheap. Several famous value-oriented hedge fund managers -including Seth Klarman- returned money to clients over the past year.

Are markets 50-70% overvalued due to cheap global monetary policies such as the Yellen Put? Will the market stagnate as a result? Monetary policy should be concerning, especially for older investors with lower investment timelines. Stagnant markets can happen. You only have to go back to the 1970s to witness a largely flat decade.

Corporate Profit Margins at Historic Highs

One of the more interesting Bear arguments revolves around corporate profit margins.

Corporate After-Tax Profit as a % of GDP - Bears Love This Chart
Corporate After-Tax Profit as a % of GDP – Bears Love This Chart

Profit margins for U.S. corporations are at historically high levels. Bears think that a mean reversion is in order.

What the Bears fail to factor in is computerization. TI believe the Digital Revolution is a permanent economic upgrade 10 years ago, most of us did not have cell phones. Now we use them to efficiently navigate from point A to point B, to interact with co-workers, to pay our bills.

Perhaps the closest historical comparison we can make is to Great Britain during the Industrial Revolution. I found a very interesting paper detailing the effects of the Industrial Revolution on profit margins. Initially, wages were stagnant, inequality rose, while profit margins doubled. Returns on capital increased in proportion, as new technology investments paid off handsomely. A feedback loop ensued as corporate profits helped to balloon GDP. Sound familiar?

The next 50 years represented a high-water mark of prosperity for the British Empire. Wages eventually caught up, while profit margins stabilized at these new, higher levels after some rather minor mean reversion. Looking at the data from the industrial revolution, it seems clear that corporate profit margins could climb even higher, by as much as 1-6%.

Takeaways

Corporate profit margins, while high, are supported by fundamental improvements in efficiency thanks to the Digital Revolution.

Every market valuation argument has an implicit time-value attached. Hedge and mutual fund managers have to outperform not just every year, but every quarter. Thus market valuation outlooks tend to be skewed to the short-term. This makes some sense if you are trading into and out of companies every week.

However, even in this case we should be basing our estimates on individual stock valuations as well as the scope/scale of opportunity sets. So market valuation really shouldn’t matter much unless you run a macro-driven fund. The scope of opportunity sets has certainly shrunken, but I think there still may be pockets of undervaluation out there.

To anyone not pulling their money out of the market in 10 years, over/under-valuation debates are largely irrelevant. It shouldn’t matter to us what the market is doing in 10 years, or even 20, unless we plan to retire soon. If you ignore market valuation and use dollar-cost-averaging to invest in an ETF or more than 10 individual stock names for the long-term (20-50 years) you can count on the following:

  • Your dividends will compound the money you put in
  • The value of your portfolio will be much larger than the value of your original investment

Portfolio Update: ANGI Short Back On, Closing out Long HSBC Position

I have decided to close out my long HSBC position after the firm posted terrible earnings this morning. It is becoming clear that the firm’s new compensation structure is not effective. Additionally, I feel that my positions in Banco Santander and J.P. Morgan represent better long-term holdings. I am not unhappy with a relatively flat return over the holding period (3% since an initial position in 2011), but there are certainly lessons to be learned.

Initial Thesis

The initial mid-2011 HSBC thesis revolved around the bank possessing stronger margins and higher ROE than Banco Santander, while at the same time being undervalued to peers. Price/Tangible Book Value was particularly attractive at 1.04. The dividend also paid over 4% at the time. London had a strong reputation as a center for international finance, and HSBC was well-respected within the space. I liked several European banks at the time, and thought investing in both HSBC and Banco Santander would spread the risk of increased regulation between countries. I also liked HSBC for its Asia focus in particular.

What Went Wrong

Regulations imposed on British banks have altered the landscape a bit. To workaround the current compensation rules, HSBC has misaligned employee compensation using stock options. Asian earnings have not grown enough to offset other geographic trends. No catalyst exists on the horizon the drive the stock higher.

The Takeaway 

I failed to evenly split my investment between Banco Santander and HSBC. Had I done so, the gain from SAN would have outweighed the lag from HSBC. As it stands, I put about 2X the investment into HSBC, because I felt that it was a less volatile play. I was right that it was less volatile, but it also under-performed the sector, and the compensation changes have hurt rather than helped. Thankfully, Banco Santander looks to be performing well. As punishment for a bad trading idea, I will be placing the money from the HSBC sale into a passive ETF for the long-term.

ANGI Short Back On as of April 30th

Short interest in ANGI has decreased, while ANGI’s results have been as terrible as always. The song remains the same:

  • Bad Business Model
  • Accruals-driven Earnings/CFO
  • Insiders Selling Out
  • “Independent” Board Members Leasing Buildings to ANGI
  • Massive Deferred Revenue
  • Growing Accounts Receivables w/Inadequate ADA
  • Large Amount of Prepaid Expenses
  • Significant Short Interest
  • Several customer-related lawsuits
  • Marketing Spend per Customer Acquisition > Lifetime Revenue Per Customer
  • Negative Book Value

I am confident this business will fail, it is only a matter of time and will be shorting for as long as I can do so without having to borrow at high rates.