Enbridge Inc. – What Asset Bubbles Look Like!


So you have some cash to invest.

 

Ten year Government of Canada bonds currently yield 2.12%.

 

Today the dividend yield of Enbridge is 2.54% without considering tax advantages of a taxable individual taxpayer.

 

Plus look at the rates of return on Enbridge Inc. over the last 5 years. Enbridge is up 180% over the last 5 years not including dividends. Chuck in the dividends earned and assume Treasury bill returns on your dividend cash and you increase the return to some 210%. That’s 25% compounded over the last 5 years.

 

Your investment advisor recommends Enbridge as an investment, considering the alternative what choice do you have. Or you’re doing equity database screens looking for possible investments and Enbridge sticks out like a lighthouse on a foggy night.

 

The investment public and financial advisors alike have no defense when they look at these numbers. With Enbridge an investor ‘pick ups’ or receives an uptick in current yield and no one has lost any money in recent memory. What is there not to like?

 

Ah! Smart Money.

 

The Fly in the Ointment!

 

Unfortunately there is something wrong here. But nobody can figure it out because it’s complicated. And we all know when things get complicated the majority of the people are lost. Hell, the whole investment industry is lost by my account.

 

What’s wrong with Enbridge? It’s overvalued. It costs too much. And we all know what happens when you overpay for something… anything? You get burned. You lose some or all of your money that you’ve invested.

 

But being wrong, or not understating something because it’s complicated won’t lose you money immediately. Nope. Sometimes it takes time. When strong money flows are being invested in a stock or investment theme usually certain fundamentals are considered but not others.

 

Because we equate making money in the stock market with being smart. But the truth is being smart and making money in the market have little to do with each other.

 

Huh?

 

Let me put it this way. I have seen some truly bright people (few I admit) in the investment business that were unlucky and financially wiped out. Yes, their analysis was top drawer. They were totally logical and analytically correct and as I remember in one or two cases… eloquent. But the market did something unexpected. “How is this possible?” each one said to me rhetorically and in a couple of instances tearfully.

 

And I have seen a lot of financially unsophisticated individuals in the financial business and some ‘stupid as a post’ (more than I care to admit) that were lucky. Right time right investment. No analysis whatsoever. Truly throwing a dart at the proverbial dartboard. And you guessed it, they were heralded as true genius. If there was a cocktail party or a crowded bar they were the ones surrounded by the most people, five rows deep, hanging off their every word.

 

When I looked at the investment business critically when I first started in the business…luck, whether good or bad, plays a very important part in a persons’ success or failure. Please don’t tell a newly minted MBA or CFA this fact. I have and received more than my share of scorn.

 

The truth is if an investor or portfolio manager is consistent with his or her investment style over long periods of time they will have good and sometimes great investment returns. However there will be short periods of time when this same investor will endure subpar to nonexistent returns not because the investor is wrong or lost his marbles its just the market or better still a sector of the market (say gold or utility companies) that can perform in such a way to make the investor and portfolio manager look stupid or out of touch.

 

So forgetting luck, let’s grind some numbers and do some analysis.

 

Snap shot of Enbridge from our Model Price app.

Screen Shot of Enbridge Inc. from our Facebook Model Price app

Screen Shot of Enbridge Inc. from our Facebook Model Price app

 

 

The first observation one can make is that our calculation of model price has always been below the stock price of Enbridge over the last 6 years. And currently Enbridge is trading at a 40% premium above its calculated fair market value. This is what I mean by expensive. Someday Enbridge will be trading at or at a discount to our calculation of model price, we just don’t know when that will be.

 

The second observation I can make is from our EBV Lines. I have looked at our database that goes back to 1995 and at no time has Enbridge traded at EBV+5! Yes, that’s almost 4 times accounting book value that for a utility with limited growth prospects is exceedingly pricey (expensive).

 

But investors don’t care. The yield differential is compelling and everyone has made a ton of money riding the boom to lower and lower Canadian interest rates.

 

Do I feel bad for missing out?

 

Nope!

 

The great reckoning will come (I’m sure of it) and besides I’ve been making investment dollars elsewhere. Places that make sense. Where the market has been discounting assets while other assets are selling at premium prices.

 

Sometimes simplistic investment themes can work to an investor’s advantage. And work over long periods of time – say six years in Enbridge’s case. But investors relying on ‘TINA’ (There Is No Alternative) will get a shock one of these days and their luck will run out.

 

Investors doing the second iteration financial analysis, Model Price Theory [MPT] analysis will be joyful and ‘lucky’ not to be picking up yield at the expense of valuation.

 

Spend any time on the Internet looking at financial information and you’ll see the phrase ‘financial bubbles’ used often. And asset bubbles can and will form in the most unlikely places (i.e. tulip bulbs). Who would expect an asset bubble in a industry sector known for conservatism and coupon clipping? Fortunes of conservative investors taking huge valuation risk for little additional income will end badly, guaranteed, unfortunately the critical question is when.

 

And to predict when you have to be… lucky or not play at all. I choose the latter.

Intel (INTC) – Model Price Analysis

What we call “Old Tech” has been on a tear in 2014.

 

Has anybody noticed?

 

Case in point has been Intel Corp. that had a positive transit of EBV+4 last week when the company reported second quarter earnings. All in all (with dividends) Intel is up almost 40% for 2014 and with a positive transit of one of our EBV Lines indicating improving corporate fundamentals and potential share gains in the future.

 

An additional fundamental positive is our calculation of model price. As you can observe from the model price chart below our calculation of fair market value for Intel is $46.25. This implies another 35% gain potential for investors sometime in the future.

 

Model Price Chart that can be found on our Facebook app 'Model Price'

Model Price Chart that can be found on our Facebook app ‘Model Price’

 

Additional Model Price Analysis

 

I was curious about Intel. Maybe something is going on here that can make me a few dollars – more than I have already made from EBV+3. I seem to recall, from the daily white noise of the business press, Intel getting into the chip (semiconductor) business for mobile phones, albeit very late in the game, combined with the fact the company has a new CEO. CEO’s are very important to the long run (secular) gains of any public company. Ask an investor in Apple since Steve Jobs returned to Apple in 1996 or long term investors in General Electric when Jack Welsh was running the company back in 1980’s and 90’s. CEOs make a big difference in rates of returns on your investments and if you can identify one early enough, invest, sit back and relax and you can enjoy a great financial ride into retirement.

 

Good CEOs leave fingerprints. Financial fingerprints. Fingerprints you can identify and see concurrently on a quarterly earnings report. Yes, we can all spot a special CEO after the fact. After this CEO added tens (and hundreds) of billions of market capitalization to the company that she runs. That’s easy.

 

In the context of investing; history is nice, but it’s the future I want to know.

 

First, I have a quick look at our long-term model price chart of Intel going back to 2007 of the Model Price Facebook app.

 

Model Price Chart that can be found on our Facebook app 'Model Price'

Model Price Chart that can be found on our Facebook app ‘Model Price’

 

Hmm… you can observe that Intel’s stock price had a positive transit of EBV+4 on two other occasions before last week. The first positive transit occurred in 2010 and the other obviously at the beginning of 2012. Interestingly both times the stock price peaked in price at mid-year before not only falling in price but also negatively transited back down through the same EBV+4. Yikes! Check your calendar; yes, it’s mid-year 2014!

 

“OK, strike one!” I say to myself.

 

But I’m still intrigued.

 

So I call up my Model Price database. My first analysis is looking at the long-term history of earnings of Intel and what is going on concurrently with Theoretical Earnings (TE). Theoretical Earnings is a financial concept particular to MPT. (For a fuller discussion of TE see ‘Key Concepts’ above.)

 

image00114

 

A few observables from the above chart

 

1. Intel’s earnings over the last twenty years have been more cyclical than I remember them.

 

2. Intel’s earnings ‘crashed’ during the financial crises of 2008 however rebounded smartly to record highs in 2012.

 

3. Looks like something happened in 2013 that caused a dip in earnings. What happened? I haven’t a clue nor do I care to find out. But a year after this dip, Intel’s earnings consolidated around the $2 a share level and look like they are returning to record highs (maybe).

 

4. Theoretical Earnings (TE) have been on a steady increase since 1995 with a dip starting in 2011 and 2012. I’m guessing here but this is probably because of share buybacks on behalf of the company. (Again I do not care why the TE is falling just that a falling TE and increasing earnings is a positive for the valuation of the company.)

 

We can look at this above chart differently.

 

I like computing a ratio between the two data series displayed above and charting the series over long periods of time. What I’m getting at with this analysis is how profitable Intel is relative to its’ own calculation of benchmarked earnings or TE. Or if you prefer the earnings of Intel relative to the size of the company’s balance sheet – a balance sheet the company’s CEO can control.

 

image0039

 

You can observe back in 1997-98 Intel was earning 9 times its TE. And having peaked at this level this ratio has fallen to a low and stable level at 2 times, plus or minus, over the last 12 years.

 

What does this mean?

 

Relative to the size of the balance sheet Intel’s earnings are quite unimpressive, somewhat stable (ignoring 2008), and a country mile from the robust years of 1997-98.

 

“Strike two!”

 

Convexity

 

The next MPT variable I call up in our Model Price database is convexity. Again you can find a definition of convexity under our ‘Key Concepts’ tab or better still I go to great lengths to discuss and define convexity in my blog on Apple and its share split (here).

 

image0052

 

Want a simple way to think of convexity? The higher the convexity number computed by Model Price Theory (MPT), the higher the valuation of the company. To crunch this number takes a lot of computer power on our part but integral to understanding the valuation mysteries of the market.   Also our convexity variable is embedded in our model price algorithm and necessary for its calculation.

 

Looking at the history of our convexity calculation you can observe that back in 1996 Intel had a convexity variable of 9 and it has been falling steadily since this peak. Again this variable is CEO controlled in the way she structures the balance sheet of the company.

 

For interest and giggles sake, with a convexity reading of 9 and a ratio of 9 times earnings versus Theoretical Earnings (TE), Intel traded at a valuation level of EBV+8 in 2000. Looking at our Facebook App for Intel shows if Intel was trading at EBV+8 today the stock price would be over $170 a share from the current $34! (Yes, that’s only a difference in market capitalization of $675 billion dollars.)

 

Both mind boggling in terms of potential gains for investors and proof what the market can reward management for good financial decision-making.

 

Irrespective of the glory days, Intel’s convexity is hitting new lows as you can observe on the above chart.

 

 

You guessed it, “Strike Three!”

 

So what does all the financial analysis mean?

 

My initial excitement on this most recent positive transit is waning. Certainly if earnings were to spike to record highs Intel could very well capture the valuation space between our model price calculation and its current trading price. Still representing a 40% upside target.

 

Not bad, yes?

 

A quick google search tells me Brian Krzanich took the reins as CEO back in May 2013. What does MPT tells us about his tenure so far? He’s no Jack Welch according to Model Price Theory (MPT).

 

Looks like just another ‘care taker’ CEO, unfortunately. I was hoping for so much more.

 

So to be clear I like Intel, and still see the value gap between where the stock is trading and our calculation of model price closing giving further gains to shareholders – see enclosed model price chart from Facebook. As of today, as I write this blog, Intel is our largest position or weight in our Acker Finley Select US 50 Fund with an unrealized gain of 47%. It’s just I was hoping or potentially intrigued that Intel may have the ability to be a 5 or 10 ‘bagger’ (5 times our original investment) that I clearly did’t see because of our above MPT analysis and hence this blog post.

Who do You Believe: Equity Analysts or the Market? – Reblog


I have been on hiatus from my blogging.

I have been upgrading my skills. Learning to ‘touch type’ so the words flow more freely, more genuine. I’m up to thirty words a minute and probably at the most frustrating part of this learned skill. Wanting to let the words fly on the keyboard but stopping way short by my fat fingers.

But I’m working everyday.

Also we are entering second quarter earnings season of 2014. My feeling is the US equity market is in a ‘take no prisoners’ kind of mindset. If any disappointment both on top line revenues and bottom line earnings the market reaction will be swift and judgmental. In other words…down. Even though the stock risk will be high, in my estimation, I still believe the market – S&P 500 – crawls higher to EBV+4.

In the mean time I will post a re blog of a blog I posted a year ago delineating the difference between our model price calculation and our EBV Lines illustrated on our model price charts. New individuals are joining and commenting everyday on the Model Price Facebook App and I believe this blog clearly explains the two pieces of calculated information we give to our users.

The blogging will be starting up again, now that at least I’m somewhat proficient at the keyboard and leaving behind the two finger ‘pecking’.

 

 

People new to Model Price have to weigh fundamental information given to them in the form of our lines on our model price charts.  Remember our Model Price charts gives or calculates two pieces of information for users – the first is our purple line or model price and the second is our parallel lines known as EBV lines or Economic Book Value lines.  Each product deliverable, model price and EBV lines, is independent of the other.  Sometimes these two data sets can confirm each other or offer major divergences from each other. I use both pieces of data independently but often give higher importance to our calculated EBV lines.

This blog post will discuss each product, model price and EBV lines, to give you a better or a more full understanding of the similarities or differences between the two.

Model Price (Purple Line on our Model Price Charts)

Our objective in the calculation of model price is to calculate what we believe to be fair market value of the company.  The algorithm that calculates this number is long and complicated but the most relevant piece of data in the calculation of model price is analysts “mean” earnings estimates.  For convenience sake we use estimates from of a group of published analysts from services that can be found on any popular financial news website.  (Yahoo is a popular example)

Whether people realize this fact but analysts’ earnings estimates change all the time when taken as a group mean average.  Individual analysts can change their quarterly estimates by fractions having an impact on the group “mean” estimate. Also material changes can occur during a quarterly earnings release and conference call, for example, as analysts adjust earnings when new information maybe released by company management impacting future financial results. We capture these changes on a daily basis and calculate a new model price based on the most up-to-date financial information. We maintain a database of our calculated model price and obviously use this price series to maintain our model price charts.

Probably the most interesting aspect of our model price calculation is the forward calculation of model price for the next year (long term model price chart – right chart) to give our users some perspective of the future trend of model price based, of course, on analysts’ estimates of future earnings.  We take great care to grow the balance sheet in future periods so the earnings estimates are current with the relevant balance sheet.  Obviously we cannot anticipate future corporate actions like M&A activity or common stock sales however most large cap stocks have stable capital structures that any projections of model price can be very accurate using past history as a guide.

For those of you who don’t know the job of equity analyst of Wall or Bay Street is one of the most demanding jobs in the security business. A top analyst can receive millions in compensation from their investment bank if they are the most accurate in terms of a company’s quarterly earnings estimate.  The pressure to be right about their coverage not only about the company itself but also the industry can be intense.  As a general rule of thumb, the larger the company the more analysts cover the company yielding higher quality earnings estimate data and relevance for the purposes of our calculation of model price.

This is the good news.

See my blog “Loblaw’s Deal with Shoppers Confirms our Model Price Calculation” as an example of our model price confirming fair market value (FMV) of a company.

The bad news is that equity analysts can also be wrong!

When company and industry trends are placid and predictable equity analysts are usually 99% on the mark in forecast quarterly estimates.  This makes sense.  Unfortunately when the company or industry is in turmoil the vast majority of the analyst’s freeze or hold their changes in estimates until the company comes clean or more information is available to quantify potential changes, usually in a quarterly conference call, or clearer trends manifest itself  in the industry.  These are major transition points where the stock price and the fundamentals of the company start to diverge.

These divergences – between the perceived fundamentals and actual fundamentals – is, in my opinion, where investors are the most vulnerable.

Enter Economic Book Value (EBV Lines)

Our second product deliverable is our EBV lines.  These are parallel lines that run through our model price charts.  Some of the EBV lines are coloured (green, blue, red and yellow for example) and others are grey or black.  In constructing these EBV lines we start with our green line or EBV.  As we add lines above our green line on a constant basis and we number each line in sequence (i.e. EBV+1, EBV+2…EBV+10). For EBV lines below or calculated green line we label EBV-1, EBV-2, and our last one EBV-3.

Once these EBV lines are constructed we add a simple open hi-lo-close price bar of the company’s publicly traded equity price.  We use a weekly price bar for our left hand chart – our definition of short-term view – and monthly price bars for our right hand chart.  It should be noted that these two pieces of data, EBV lines and public equity prices, interact independently of each other.  When the stock price of a company transits an EBV line, either positively or negatively, fundamental information is given to the observer of our model price chart.  A positive transit, stock price transits up through one of our EBV lines indicates fundamentals are improving for the stock in question and conversely if the stock price has a negative transit fundamentals are deteriorating.

Magically over time and experience users of model price will become convinced of the usefulness of our EBV lines. Equity prices of companies seem to use these EBV lines as support and resistance.  When transits do occur, both positive and negative, usually prognosticate major future company news that can have a major influence on the company’s future share price and direction.

See my blog “$76 Billion Reasons to Sell Gold Stocks.

These computed EBV lines can also give observers a quick reference point in terms of a company’s valuation.  When comparing a basket of equities together in indices or in the same industry an observer can quickly evaluate the valuation of the company in question.  For example, company ABC can trade above EBV+5 where as company XYZ may trade just over EBV+3 indicating a lower market valuation level for comparative purposes.  Our computed EBV lines can provide a quick reference and apples to apples comparison of individuals companies.

Back to the question, “Who do You Believe: Equity analysts or the Market?”

So you, the user of our Model Price App, get two pieces of financial information of a company that appears no where else on the internet and is not taught in any financial course at university – Model Price and EBV lines.

Users of Model Price App, a service that provides these calculations, have to weight these two pieces of information carefully.  Yes, knowing the fair market value of a company is indeed insightful when contemplating either a sale or a purchase of a particular company however analysts are the primary driver of this calculation and users should know their fallibility.  Where as our EBV lines are derived from the company’s balance sheet that in my opinion is more robust – a balance sheet has to balance after all  – and less likely manipulated by management, except in the case of fraud.

In a nutshell a lot of times, these two pieces of information – Model price and EBV lines – are confirming each other.

Here is a recent example of Yahoo having a positive transit of EBV+3 being confirmed by a positive and upward sloping model price calculation.

Yahoo Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Yahoo Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

At major transition points, in equity markets in general and company dynamics in particular, I weight our EBV lines more heavily than our model price calculation. “The Market” is usually smarter at transition points than the equity analysts following the company on a group basis.

Barrick Gold back in February 21, 2013 having a negative transit even through our model price calculation is substantially above the current selling price is a good example of the divergance between model price and our EBV lines.

Barrick Gold Corp. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Barrick Gold Corp. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

The weighting of the relevancy between model price and our EBV lines usually takes the user a short period of time and experience however in my opinion worth the time spent in terms of profitable investing.

July 2014 – Monthly S&P 500 Market Strategy Update

Ditto!

 

“Sorry what was that?” you say.

 

I opened last month – June 2014 – Monthly S&P 500 Market Strategy Update – with the opening, “What can one say about the US equity markets? No real volatility and hitting new highs everyday!”

 

What else can I say but the obvious…ditto!

 

As usual let’s have a look at the model price chart of the S&P 500 Index.

 

S&P 500 Index Model Price Chart

S&P 500 Index Model Price Chart

 

 

As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.

 

As you can observe the US market, as defined by the S&P 500, is still in the middle of the zone bookmarked by EBV+3 and EBV+4. If the market rallied to EBV+4 (2162) this would represent a gain of some 9%. If the market corrected back to EBV+3 (1728) investors would be suffering losses of 13%.

 

This is the first time this year where the risks for the US equity investors outweigh the upside rewards since the positive transit of EBV+3 back in May of 2013.

 

Should US equity investors be alarmed? No. For me it’s just a reminder that risk is ever present and growing. I do look at my portfolio of stocks and ask, “Do I have too much?” And if I do I lighten up.

 

Of course it’s hard. Yes, I’m making tons of cash just holding my positions. But I have been in this game too long not to understand market risk. To me risk is being in a position of NOT buying more when the situation arises. Can you image having Apple (AAPL) pulling back to EBV+5 on a market pullback and NOT being in a position to buy more. That’s how I define risk. So I sell some Apple here. Make sense?

 

More than anything Model Price Theory (MPT) is about assessing risk/reward and investing a highly probable market or equity bottoms. Users of Model Price should always know where their individual equity positions are relative to their trading (EBV) zones including the overall market – S&P 500 Composite.

Since I began this blog quoting from the June market strategy blog, I will end it in the same way.

 

“So relax, take it easy because second quarter earnings are on the way and with September and October coming; these two months always seem to be eventful for one reason or another.

 

As always, see what happens.”

I’m on Market Call!

On Thursday, July 3rd, 2014, I will be on Market Call on the BNN network (Canadian Business Show) 1:00 pm – 2:00 pm (eastern standard) with Mark Bunting.

Take this opportunity, open our Model Price Facebook application and follow along while I’m on the show answering viewer’s questions about individual stocks.

Would you say anything different based on your interpretation of Model Price Theory and chart?  You can make your comments via Facebook.

Should be fun!

modelprice

Goose Bumps from Our EBV Lines – Lululemon Athletica Inc. (LULU)

 

Fifteen years. Yes, fifteen years I have seen and witnessed model price math. And I still get goose bumps. Man, look at this chart from last night’s computer run. Look where the price of LULU stopped and paused. Amazing EBV+5. Think about this, EBV+5 was predetermined and computed before the stock price arrived and stopped falling. I have seen this over and over again for 15 years and I still get a thrill every time I see this. It’s magical. Tens of thousands maybe millions of people trading shares – Adam Smith’s invisible hand – and share prices conform to our EBV math.

 

Chart from our Model Price Facebook App

Chart from our Model Price Facebook App

 

How is this possible?

 

These mathematical points, these EBV lines, come from natural phenomena observed from nature – yes that’s right ‘mother nature’.

 

“Are you kidding me!” you say.

 

No I’m not.

 

If you are looking for an edge in your stock trading Model Price Theory (MPT) is a ‘new country heard from’ and very simplistic.

 

I would say elegant.

 

I get the question all the time, “How do you know these EBV work?”

 

“They just do!” I respond.

 

Not a very satisfying answer I know both for the questioner or myself. So I have to document. I have to point out the obvious whenever it happens. I have had 15 years of being amazed of how equity prices conform to these simplistic multi-colored parallel lines.

 

I have made big dollars from using these EBV Lines. It is worth your time and effort to have a look.

 

And I hope that 15 years from now you still get goose bumps, as I do, observing stock prices interact with these EBV Lines.

 

Dai-ichi Life Insurance Deal with Protective Life Confirms Model Price

What are individual stocks worth in the publicly traded equity markets?

 

This question plagued me for sometime not only early in my financial career but when I started taking finance courses in university. Would you believe the world of finance doesn’t know this basic question? Sure there is the famous ‘Discounted Cash Flow’ [DCF] calculation but having spent 5 minutes doing this calculation and the amount of guess work about time frames, normal business activity and interest rates (discount rate) makes, at least in my mind, the DCF calculation dubious and imprecise. The other well-known calculation of fair market value can be what is known as ‘Enterprise Value’. Again spend any time with this calculation, and its simplistic nature and I have always wondered whether there is a better way.

 

Unfortunately in today’s financial world, there seems to be no definitive or agreed upon technique – algorithm – about what a company is worth especially public companies. In other words, business valuation is more art (justification) than science (math).

 

Enter Model Price

 

After many years of hard work and R&D our algorithm – Model Price – was born in 2002. I have been observing our model price calculation for over 12 years. Four years ago we decided, conceptually, to release Model Price to the public on the Facebook platform. Two years ago we released our Model Price App (Application) on Facebook. This application allows the general public to view our model price calculation (and history) in our database of stocks – over 2,000 companies both Canadian and US listed – at your convenience.

 

Our algorithm – Model Price – is so robust that we can calculate model price or fair market value for all companies in our database no matter what kind of business or peculiarities a specific industry sector may inhibit, like banking/finance. In my opinion model price represents a major break-through in security analysis and helps me considerably in the evaluation of individual public companies for investment.

 

Hopefully model price can help you as well!

 

However in order for you to use model price you have to be convinced that our calculation – algorithm – is relevant.

 

How do I do this?

 

Certainly one way is to evaluate M&A activity, where independent parties come together and make acquisitions on an arms length basis. This transaction price would certainly be considered fair market value especially in the transparent world of company boards, investment bankers and various experts on both sides of the transaction.

 

Yesterday morning Japan’s Dai-ichi Life Insurance agreed to acquire Protective Life Corp. at $70 per share. What was our calculated Model Price for Protective Life you ask?

 

Here is Wednesday’s model price chart for Protective Life Corp. (PL) after the transaction was announced and our calculated model price of $70.44.

 

Protective Life with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Protective Life with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

 

Conclusion

 

Our simple dashed purple line, included on our model price charts, probably looks superficial to the sophisticated and complicated world of finance. I prefer elegant!

 

In my opinion the world of security analysis and investing becomes a much more interesting place when participants begin to realize and have confidence in what the true fair market value of a public company really is. Maybe investing becomes much more ‘rational’, at least for those who use Model Price and may have a significant impact on your net worth.

 

I have seen model price work for over 12 years. I know this simplistic purple line ‘delivers’ the goods in terms of fair market value. I also realize I need to prove to you that our calculation of model price is relevant. Hopefully this transaction and others are a step in the right direction to that result.

Other links to transactions that have confirmed our model price calculation.

Loblaw’s Deal with Shoppers Confirms our Model Price Calculation

Canada Bread – Confirming Model Price Algorithm

Warnaco (WRC) Acquisition Confirms Model Price Calculation

CVH – Aetna to buy Coventry Health. Confirmation of Model Price.

BCE – Agreed to Acquire Astral Media “A” for $50 per share

 

June 2014 – Monthly S&P 500 Market Strategy Update

What can one say about the US equity markets? No real volatility and hitting new highs everyday – it seems.

 

As usual let’s have a look at the model price chart of the S&P 500 Index.

 

S&P 500 Index with EBV lines

S&P 500 Index with EBV lines

 

As a reminder we aggregate all companies in the S&P 500 Index into one chart on a market capitalized basis (like the S&P 500 Index itself), so we can see where the market – S&P 500 – is trading relative to its EBV lines.

 

As you can observe the US market, as defined by the S&P 500, is still in the middle of the zone bookmarked by EBV+3 and EBV+4. If the market rallied to EBV+4 (2142) this would represent a gain of some 11%. If the market corrected back to EBV+3 (1712) investors would be suffering losses of the same 11%.

 

Getting ready for the ‘Dog Days of Summer’

 

Summer is finally here after a long and painful winter and iffy spring. One of the old quotes about the market handed down from one generation to the other is “never sell a dull market short”. I think this quote is apt because superficially the US market does seem dull. However on a daily basis all the major US indices seem to be a few points below their all-time highs until a late afternoon rally pushes them forward (up) giving the financial press and media urgency to report ‘all-time market highs’ to the distracted and disinterested.

 

“Does anyone really care?” I ask myself frequently.

 

So what is there to say? After a fairly slow economic report for the first quarter of 2014 – US GDP contracted 1% – everyone is looking for a reacceleration of economic activity for the rest of 2014. Equity values are still cheap (S&P 500 just over EBV+3) with lots of room to the upside.

 

So relax, take it easy because second quarter earnings are on the way and with September and October coming, these two months always seem to be eventful for one reason or another.

 

As always, see what happens.

Apple’s Stock Split – Why Stock Splits do Matter!

With the news of Apple Inc. announcing a 7-for-1 stock split, the subject of stock splits have been in the financial news often. The consensus from journalists and academics alike seems to be that stock splits don’t matter – a simple division exercise.

What if stock splits do matter? What if the very act of splitting a company’s stock price, in this case Apple, from the low $600’s to $90 a share substantially increases our calculation of fair market value or model price?

What if I disclosed here that Apple’s “innocuous” (I will explain this quote later in the blog) 7-for-1 stock split increased the company’s fair market value by 22% or a cool $120 billion dollars.

 

Heresy, you say!

 

Let’s examine or parse a couple of financial articles – one article and one video – discussing Apple’s stock split that I found interesting over the last week.

 

The first article that caught my eye on the subject of stock splits was written by Mr. David Milstead of the Globe and Mail’s Report on Business. (Thursday, May 29th)

 

Mr. David Milstead writes.

 

Apple’s split is scheduled for June 9, benefiting all who own the shares as of June 2. In the strictest sense, the split will “do nothing,” [referencing Tim Cook’s comments on stock splits some time ago], as one Apple share trading at $700 is no more valuable than seven Apple shares trading at $100. That’s the basic economics of a stock split, and the reason why market professionals say splits have little meaning.

 

David continues,

 

Academic research has suggested stocks that split tend to outperform the shares of similarly sized companies in the near term…

 

Yes, this above noted phenomena has been reported in academia for quite sometime (over performance usually after the announcement of the stock split) and David continues his thought by offering what some academics are thinking as to why these gains are seen.

 

… in part because they’re an underappreciated signal of confidence: A management team that recommends a split to its board is confident the shares won’t drift lower.

 

Huh?

The other article (video) of note on the subject of stock splits comes from the 67th CFA Institute Annual Conference held in Seattle this past May (2014) .  (OK, I can’t help myself poking fun at these guys!)

In this video (6:46 minutes) Mr. John Authers of the Financial Times interviews Mr. Aswath Damodaran, professor of finance at NYU Stern Business School about Apple.

 

https://www.youtube.com/watch?v=pc0eUW_ChSk&feature=youtu.be

 

In this interview, Mr. Damodaran correctly comments that in 2013 Apple announced a cash dividend (its first ever), corporate stock buybacks and significant borrowings (debt) and Apple’s stock did nothing to trend lower. He continues his observations by noting in April of this year Apple announces a dividend increase, more corporate buybacks, additional borrowings and an “innocuous” (7-for-1) stock split; further observing “seems to have triggered a move in the market [of the stock]”.

 

What’s going on here? Antidotal evidence seems to be piling up? Stock splits seem to have an unexplained positive impact on share values even though the simplistic theoretical textbook explanation seems to be wanting.

 

Enter Convexity

 

Model Price Theory (MPT) has many new concepts to offer the field of finance and investment management. Each of the new and original concepts – see Key Concepts tab – is grounded in a theoretical framework that is unique to MPT. Our convexity calculation variable is so important it’s one factor in our 3-factor algorithm that produces our model price value that you see on our model price charts.

 

Of course all public companies produce financial statements that include a balance sheet. All balance sheets have unique qualities that are specific to the company’s business, industry and choices made by the CEO and the Board of Directors on how they want to run the company. By analyzing each company’s balance sheet Model Price Theory (MPT) determines how the economic structure of the balance sheet is configured. More specifically a company’s economic structure can be viewed as a convex curve representing the specific nature of the balance sheet in question.

 

After a multitude of calculations we produce a convex curve that is unique to each company in our database. Some companies have very steep convex curves while others are relatively flat. The companies with steep convex curves may have little or relativity small amounts of recorded capital on their balance sheets’ for the simple reason they need little to no capital to run their businesses. Conversely companies that have very large balance sheets, relative to the size of the business, have convex curves that are relatively flat.

 

An example of a Convex Curve calculated from a public company's balance sheet

An example of a Convex Curve calculated from a public company’s balance sheet

 

So why should anybody care about the steepness of some calculated convex curve?

 

There are a lot of influences that are brought to bear on a public company’s stock price. One of the influences, according to Model Price Theory (MPT), is the feedback between the actual stock price dollar value and the calculated convex curve. As the stock price value (the actual number) moves up or down and depending on where the dollar value and the steepness of the convex curve intersect, feedback between these two variables will impact the fundamental value or fair market value of the company.

 

Assuming a company has a highly convex economic structure and a very low stock price (say penny stock), the feedback between the two can cause the stock price to be volatile. As the stock price increases in price value, say from $0.80 to $0.85 cents, the fundamental market value of the company increases substantially more than the change in price value because the steepness of the company’s convex economic structure curve. With the fundamental market value of the company increasing exponentially relative to the price movement may provide a further warranted price move, say $0.85 to $0.90 cents, recognizing the positive change in fundamentals. This feedback loop, between the company’s stock price and the convex economic structure of the company’s balance sheet, can go back and forth creating visible stock price momentum – oversized capital gains.

Unfortunately before you get too excited about this phenomenon the same feedback loop can happen on the downside as well.

 

Anecdotally this explains why lower priced stocks have more actual price volatility, especially penny stocks, than higher price stocks. Also this feedback loop is prominent in what is known as momentum stocks.

 

We Reduced Convexity to a Single Variable

 

We realized that looking at convex curves and their steepness was going to be a lot of work and interpretation. So we computed a variable that would combine the steepness of a company’s convex curve with the stock price dollar value of the company. So a company that has a convexity value of say 1.5 has a lot less convexity or share price feedback loop than a company with convexity of say 5.0.

 

Make sense.

 

With this background let’s start talking about Apple, Inc.

 

First let’s look at this table comparing the convexity values of the undernoted companies.

Companies Convexity Score
Microsoft Corp. 1.58
Oracle Corp. 1.54
Intl. Business Machines Corp. 1.14
Intel Corp. 1.65
Cisco Systems Inc. 1.89
S&P 500 Index 1.27
Apple 0.12

 

 

As one can see Apple’s convexity score (value) is very low compared with other large capitalized technology companies and the S&P 500.

 

If Apple’s management increased it’s convexity value the calculation of our model price or fundamental value would also increase.

 

So how do you increase Apple’s convexity?

 

There are two ways of increasing Apple’s convexity. The first is to focus on the balance sheet. Reducing the overall size of Apple’s balance sheet would make Apple’s convex curve steeper. This steepness would enhance the feedback loop between the positive stock movement and its fundamental value. Apple’s management starting in 2013 started this process by initiating a cash dividend and corporate stock purchases. Both of these actions in effect reduce the size of Apple’s balance sheet. Unfortunately the dollar size of these above noted corporate actions with Apple’s ample ongoing cash flow has had a negligible impact in doing anything to our convexity calculation. Laughingly with Apple’s bond deal (replacing Apple’s depleted cash) Apple’s convexity has gone from 0.14 back in January 2012 to 0.12 as of last week. You can see why Apple’s share price has languished for much 2013.

 

The second way of increasing convexity is to lower the stock dollar value of Apple’s share price. Yes, by doing a stock split. The lower the stock price dollar amount the higher convexity value computed. (Note: the act of splitting a company’s stock and lowering the monetary value of the stock price will not change the shape of the company’s convex economic structure curve but will change the intersection or the steepness where the Apple share price intersects on our computed curve)

 

Apple’s management shocked everybody, including myself, by announcing a 7-for-1-share split in April. So the question is what would happen to our calculation of convexity value with this corporate action. Not surprisingly our convexity value will increase from the present value of 0.12 to 0.84. This is probably one of the largest jumps in convexity I have ever seen – granted there are only a handful of companies with convexity value as low as Apple’s to begin with.

 

So what does this mean?

 

Below I have reproduced our model price chart of Apple, Inc. for Wednesday, May 28th from our Facebook application.

 

Apple's Model Price chart on Facebook captured on Wednesday night

Apple’s Model Price chart on Facebook captured on Wednesday, May 28, 2014

 

I have annotated on the chart where Tim Cook announced the stock split and the market’s positive reaction. This announcement helped close the gap between Apple’s share price and our calculation of fair market value. This is the fundamental view of how Apple looks at present and note that our calculated model price value is $628.99.

 

For fun, (yes, it’s fun) I split Apple’s stock in our database on the announced 7-for-1 basis and allowed our algorithms to recompute a new model price value allowing for the recalculated change in the value of our convexity score because of Apple’s lower stock price value producing the model price chart below.

 

Apple's new Model Price chart showing the impact of the 7 for 1 share split as of the same Wednesday May 28, 2014

Apple’s new Model Price chart showing the impact of the 7 for 1 share split as of the same Wednesday May 28, 2014

 

 

No other data inputs have been changed from the original Apple model price chart produced above. The only change I made was the share split announced by company’s management. With a lower share dollar value producing a higher convexity value (0.12 to 0.84) Apple’s new model price value would be $109.50 post split. Multiplying Apple’s new model price of $109.50 times 7 is $766.50.

 

Yes, just by changing the dollar value of Apple’s share price through a share split Apple increased their model price from $628.99 to $766.50! That’s a 22% increase or $120 billion increased in Apple’s market capitalization. Not bad!

 

Conclusion

 

Share splits do have an impact on fair market values of publicly traded companies both in terms of intrinsic fundamental value and over performance contrary to ‘experts’ in the field of finance and investment management. Model Price Theory (MPT) through our mathematical variable called convexity can help explain why share splits can have positive impacts on share price performance. By doing an “innocuous” share split Apple’s management will benefit all stakeholders, especially common shareholders, in making Apple more valuable. Hopefully through management’s other corporate actions we’ll see a steady increase in our convexity value further increasing the fair market value of Apple in the future.

I’m on Market Call!

On Thursday, May 29th, 2014, I will be on Market Call on the BNN network (Canadian Business Show) 1:00 pm – 2:00 pm (eastern standard) with Mark Bunting.

Take this opportunity, open our Model Price Facebook application and follow along while I’m on the show answering viewer’s questions about individual stocks.

Would you say anything different based on your interpretation of Model Price Theory and chart?  You can make your comments via Facebook.

Should be fun!

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