The principle underlying everything Framework does is that an investor must understand the process by which companies generate value to invest successfully over the long term. It has taken me years of trial and error – both personal experience and standing witness to the actions of others – to distill and refine Framework’s methodologies.
One thing that I emphasize in my own work is the process by which I check my own operational understanding of and forecasts for a company with the company’s actual results. In my experience, this process of consistently and objectively comparing expectations to reality is 1) the principle on which all scientific and human process has been made throughout history, 2) vital to long-term investing success, and 3) strangely, something that investors and analysts rarely do consistently.
General Electric issued its third quarter financial statements on Monday, and I’ve spent some late nights this week looking through them. The actual results for the third quarter and for the year so far are considerably different from my expectations for this year.
For the last few days, I have been struggling to reconcile the mismatch between my forecasts and actual results. Does a quarter (or in this case, three quarters) of results lower than my forecasts mean that my valuation is wrong? Shouldn’t I do another valuation of the company to reflect the current quarter’s weakness?
On the other hand, changing my valuation assumptions now seems suspiciously like something the short-sighted investors I often criticize might do. I will not have a full year’s worth of results from GE until February or March of next year, so what basis would I have to change the model anyway?
The drop in stock price has been painful to me because my allocation to GE makes up a significant proportion of my personal portfolio as well as what a mutual fund manager would consider a full-sized position in my family’s portfolio. I’m conscious that humans often feel psychologically better after taking action, even if that action is objectively wrong, so am doubly suspicious of an urge to revalue the company now.
After a great deal of thought about this, I have decided to return to first principles. The underlying principle on which our valuation framework is based is that we should value a firm on the basis of its structural, rather than temporary characteristics.
Rereading the quarterly report and the conference call transcript, I realized three things:
- The short-term demand environment underlying most of GE’s business is presently strong, and the long-term demand environment is tied to the ongoing flourishing of the human race.
- The overlapping Alstom and Baker Hughes acquisitions have created a lot of one-off cash charges this year. In addition, an increase in the complexity of long-term projects, brought about by the firm’s wider product and service offerings, creates cash flow timing issues.
- The Power business has, over the last few years, increasingly relied on more volatile, short-cycle business to make its numbers. The weakness in the Power business highlighted in JP Morgan’s report and discussed in Office Hours was real, but because the business was more reliant on short-cycle business, the weakness became evident this year, rather than in 2018 as I had expected.
The first two issues deal with cyclical or temporary factors. The third issue has more of a structural component, but also has temporary or timing-related features. Specifically, a good part of the cash flow weakness this year is related to a build-up in inventories and another portion is related to a delay in the signing of service contracts from this year to next.
On balance, while the company certainly has well-publicized issues related to execution and cost control, to a large degree, the root cause of the discrepancy between my expectations and the firm’s actual results look like transitory rather than structural issues.
This article is meant to present more of a big picture view of the situation, but I will publish another article with specifics and I am also happy to discuss during Office Hours.
The firm’s new CEO, John Flannery, will present his plan for capital allocation on November 13th, at which he is expected to make an announcement related to dividend payments. I am most concerned, not with whether the firm pays a dividend, but whether it has a pool of cash out of which it may pay dividends. As such, I won’t speculate on the outcome of that meeting, but by my reckoning, the firm should be able to maintain its dividend next year if Flannery decides that is indeed the best use of cash.
Speculation over a dividend cut, some well-publicized stories about GE’s corporate bloat, and a stock price that seems only to go down has created a great deal of negativity regarding the stock amongst dividend investors, value investors, and momentum investors – a perfect trifecta of bearish sentiment.
As an investor, this negative sentiment is probably the best short-term news I see, since if actual conditions are even somewhat better than expected, some of that negative sentiment may flip positive.
I acknowledge in myself a penchant for underdogs, complex transformations, and turnaround stories, and GE is certainly an example. In doing valuations and making recommendations, I strive to generate long-term value that is greater than what might be generated by other investments, but as I pointed out in a recent article, the market is not a juke box and you don’t always get the song you want immediately after you put your quarter in. While I’m upset about my own portfolio’s performance, I am more bothered that my recommendation has not yet worked very well for Framework members.
This year has been a hard one, and even in the best of cases, it’s hard to imagine GE finishing the year with anything other than a loss. Wilson M. sent through an article from Barron’s detailing the “double-up strategy” — a way to book a tax loss without a permanent change in your position. I always get myself in trouble when I try to be clever, so will not be doing this, but have a read through in case you are interested.
The humble “double-up strategy” is worth considering for anyone who wants to maintain ownership of the stock, and also realize a tax loss. For example, if you own 1,000 shares of GE purchased at $32.38, which is the 52-week high, or at higher prices, buy another 1,000 shares at the current price. Then, hold both positions for at least 31 days. On the 31st day, sell the stock bought at the higher price.
The 31-day stricture is critical. If you sell before that period ends, you will violate the Internal Revenue Service’s wash-sale rule and the loss will not be allowed.
I still do not have any idea where GE’s stock price will go in the short term, but by returning to first principles and looking at the firm’s structural capacity to create value, I am at least content to hold my ground. I have a list of things that I will be looking for in GE’s future announcements and will post that as a separate article soon.