Ford reported 1Q14 earnings before the market open on April 25th that were below analysts’ expectations. In response, the shares fell over 3% to close slightly below the average price of our investment. In our opinion, the earnings announcement contained very little material information regarding valuation.
IOI Position in Ford
We bought 150 shares of Ford’s common stock on April 9th at an average price of $15.9972 / share and paid transaction fees which brought the average price up to $16 / share. This represents an investment of $2,400, which is just over 5% of the model portfolio’s total value.
For most mutual funds, a 5% position in a single stock is a fairly large position, but for the IOI model portfolio it is modest. Boosting diversification by taking small positions in a large number of stocks has some merit in certain situations, but there is a good argument to be made that institutional investors diversify to reduce career risk more than they do to reduce the market risk of their clients’ assets. This topic is worth an article of its own, so I will take it up in another post.
If the price falls further–to somewhere around $12 / share–I will likely start looking for opportunities to sell puts and / or enter into a long diagonal (where a sold put subsidizes a purchased call). If the stock breaks $10 / share, I will look to increase our position in the company using both shares and options.
Considering how excited the market gets every 90 days when earnings season rolls around again, it is remarkable how very little material information is presented by companies.
Ford reported sales that were slightly better than sell-side analysts expected, but lower profits due to higher than anticipated warranty costs and larger than anticipated South American currency fluctuations.
North American auto sales were weaker than some analysts had expected, but one of the central theses of my Focus Report on Ford (mail me for a copy) is that the North American market is likely to be weak and counting on a huge wave of demand for automobiles is folly.
Surprisingly, Asia–led by China–generated good profitability and Ford touted its market share gains there. I personally am not counting on gains in China and think that Ford is too late to the party. After listening to Jim Chanos speak at Vitaliy Katsenelson’s ValueX Vail conference last year, I am not sure that being late to the Chinese party is a bad thing.
Insider Information about Ford
It just so happens that the newest hire to YCharts comes to us from the Ford Credit accounting department. He told me two things that I found particularly interesting:
First, car companies–including Ford–have recently been extending the leasing period for new car leases. This may not be a surprise to anyone else, but considering that I have never even thought about leasing a car, and that the last car I bought (off a lease) is already in its eighth model year, I found this data point very interesting. My thesis regarding demand is that middle class incomes and wealth are stretched to a point at which most people are hesitant to buy a new car. Car companies have long used leasing as a way of maintaining affordability while all the while increasing the sticker prices of their automobiles. Longer lease periods imply that the companies are attempting to spur demand by superficially increasing the affordability of their products and thus confirms one of my main investment theses. In short, don’t hold your breath for a huge wave of automobile demand.
Second, internally at Ford, the decision to start using aluminum rather than steel for the bodies of its F-Series pick-up trucks is considered a risky gamble. I read about the aluminum bodies when I was researching the company, but frankly, thought that information was not material. Production problems or customer preference-related demand weakness may well crop up, but these sorts of issues will certainly work out in a fairly short time period. In addition, I think they should have a better chance than not of being well-received in the market place (aluminum bodies are lighter, so more fuel efficient and likely can be made as durable as steel).
All things considered, my discussions with a Ford insider made me think that the theoretical structure with which I am framing this investment is generally correct.
Misapplying Market Multiples
Market multiples are the duck tape of the investing world: they are often used in a way that is inappropriate and unattractive (Duck tape, however, probably has higher task efficacy than do market multiples…)
Market multiples are indeed very useful financial tools…for corporate financiers whose investment time horizon is measured in weeks, not years, and who have very complete and detailed acc
ounting information about the firms they IPOing.
Many market participants estimate the value of a stock as a multiple of its EPS (or some other financial statement term). For instance, XYZ company should trade at 14x EPS, so if EPS is $1.00, it should trade for around $14 / share.
This valuation method is the financial equivalent of giving someone a haircut using hedge clippers. First, it begs the question of whether EPS is a reliable number (I would argue that in many cases it is not), and second, it completely obfuscates information about future cash flow growth rates.
This latter point is one that many value-oriented investors overlook, especially when assessing relatively young firms. A typical and fallacious investing argument might go like this:
“ABC is trading for 50x TTM earnings–that is not sustainable! I’m going to short it.”
Indeed, 50x earnings is not a sustainable valuation, but many companies increase their earnings so quickly that the “50x” number comes down very quickly to more “sustainable” levels even as the stock price continues to rise.
Ford “missed” analysts’ expected earnings by $0.06 / share. For many market participants, this difference between expected and actual EPS necessitates a revaluation of the firm lower. All I can say is that I am glad that people look at stocks this way. It provides good opportunities for intelligent investors to profit from people who have a shallow understanding of what creates value at a firm.