EBay, Mr. Market, and Amazon's Q2 Results

This is a shared post with understandingamazon.com, re-posted here because of its obvious ties to the Shleifer Effect, Mr. Market, profitability bias, and other investing concepts we discuss. 

Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon's current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market's reaction...let's just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo's always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching - ever so briefly - its own 52-week high.

One of those important Wall Street metrics is eBay's Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market's logic...

Since Amazon has been crushing the e-commerce growth rate, outpacing it 2:1 with Q1 results in April when Amazon increased revenue 34 percent. And...with eBay showing it can match industry growth in the most recent quarter, then there must be some good tailwinds for e-commerce right now. Ergo...Amazon is going to kill it with Q2 results next Thursday! So let's bet on Amazon! 

Well, Mr. Market, you may be right. I'll grant that Amazon will probably outpace industry growth yet again. But what happens if earnings - once again - don't follow revenue growth? Moreover, what if earnings  (gasp!) disappear altogether for Q2 as Amazon has suggested is a distinct possibility?

Going Back in Time (But Just a Little)

Let's go back in time to look at Mr. Market's previous reactions to Amazon's earnings. We'll use some charts based on Wall Street analyst estimates of Amazon's performance (provided here by Businessweek) and go backwards from most recent.

Last quarter, Q1 results, Amazon surprised Mr. Market by earning .28 cents per share. This after his consensus estimate was .07. The stock shot up about 15 percent in the two trading sessions immediately following the news. It was the second such positive report, which leads us to...

Q4 of 2011 Amazon reported .38 cents per share. Mr. Market has expected .18. A 110 percent upside surprise. The stock actually fell seven percent on the news. Maybe that's because Mr. Market still had not recuperated from the hangover caused by the previous quarter's different kind of surprise...

In Q3 of 2011 Mr. Market had high hopes for Amazon. He was expecting .25 per share after Amazon had posted a hefty .41 cents per share in the previous period. He was hoping for the trend to continue, and in anticipation of it he had run up the stock price by about ten percent since the last earnings announcement. Amazon only earned .14 cents per share. Mr. Market's great hopes were dashed, and he punished Amazon, sending its stock price plummeting from about $225 to about $200 within a couple days. It went as low as $173 before starting to climb back up again.

Over this past year, Amazon has been nothing if not volatile. Google Finance is quick to highlight its 52-week range as 166.97 - 246.71. That's a wide spread, indicative of Mr. Market and this game of expectations he likes to play...and the bi-polar extremes that take over depending on whether Amazon has lived up to his expectations.

Q2 2012 and the Profitability Bias

Well Mr. Market's expectations for next week's results are not too lofty. At least as conveyed by the consensus estimates. It's at .03 cents per share (though the range is quite wide: .17 cents on the high side and .23 LOSS on the low side).

But the reaction today to eBay's results suggest to me that there exists loftier expectations than he's letting on to with the estimates. I think he secretly expects HUGE revenue numbers that will wow investors into paying even more for the privilege of owning shares.

I wouldn't bet against that happening. But even if the big revenue numbers come in and earnings disappoint, this faith in Amazon's upward performance trend is going to be dashed. And Amazon losing money in Q2 is a very real possibility. (Its guidance from the Q1 press release said this: "Operating income (loss) is expected to be between $(260) million and $40 million, or between 229% decline and 80% decline compared with second quarter 2011.") We know how heavily the company is investing in growth, and how willing it is to let those growth costs eat up profits. (See Amazon's Rapid Sales Growth...Buying the New Business?)

So, even if revenue growth blows us away, losses tend to shake investors' faith. Why? The profitability bias. It's almost as if we have an instinctive visceral reaction to seeing losses in a business that was previously showing earnings. We just can't help but think more losses are coming, that there's something wrong with the company, and that the losses will extend into future quarters. We have very weak stomachs for these things. Even if we know the business has staying power, is investing heavily in initiatives to make even better profits in the future, or is just going through a temporary funk. We just get spooked. We overreact and send the price down.


That's the basis for the Shleifer Effect. 

Note that I'm making no predictions for Amazon's results next week. I am, however, highlighting the appearance of high expectations combined with the POSSIBILITY (nothing more than that) of Amazon not satisfying those expectations. Plus, we've seen what happens to the stock price when Mr. Market's expectations are dashed.

I'll end with this incredibly inappropriate teaser...

Amazon finished today at 226.17. That's almost exactly where it was immediately prior to the Q3 2011 update when it disappointed and proceeded to fall to its year lows over the next three months.

Fooled By Randomness and Shleifer Effect

In this my third reading of Taleb's Fooled By Randomness in the past five years, my attention is drawn to a section he calls The Earnings Season: Fooled by the Results. Its description (below) is reminiscent of (or prescient of) the Shleifer Effect. It creates interesting questions about the model and how/whether it's tied to randomness.

First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I've already conceded (here) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb's book, I would assume his thoughts have influenced the Shleifer Effect as well.

From pages 164-5:

Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting - stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. 

Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 "star" companies showing an increase in profits (assuming no inflation), and 5,000 "dogs." After three years, we will have 1,250 "stars." The stock review committee at the investment house will give your broker their names as "strong buys." He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.

Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book Inefficient Markets, Andrei Shleifer's assumption seems to be that chance determines whether a company's earnings go up or down. He does not concern himself with competitive advantages protecting profits. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter.  So it is chance. 

I don't think that's his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.)  The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.

That's Taleb's point here, too. I think. He constructs his cohort of 10,000 companies that "engage in all forms of volatile business." Perhaps I'm reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage. 

Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer's predicted overreaction. And it happens on the upside and the downside. 

For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside...BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.

Nike Entering Shleifer Effect Watchlist

I'm catching up on some of my screens from last week, and I notice that Nike (NKE) took a big hit on news that it missed consensus earnings estimates by about 15 percent. The price dropped over nine percent on the news.

MarketWatch provides a news write-up here. Revenue was up 12 percent for last quarter, but earnings dropped about eight percent. Costs went up, the company increased marketing spending in preparation for the London Olympics, orders from China dropped quite a bit, and it reduced it earnings growth guidance for the year.

Here are some of the analyst quotes pulled from  MarketWatch article (mainly for entertainment purposes):

It’s “a rare miss for Nike,” said UBS analyst Michael Binetti, who added he’s “disheartened to hear” that the company’s gross-margin recovery will be pushed out again after three straight quarters of missing its own targets.

“Nike becomes a much trickier stock from here,” according to ISI Group analyst Omar Saad. Sales “may no longer be enough for investors to overlook the company’s perplexing ongoing margin pressure.” Saad also said the margin miss makes him “a little concerned that this highly sophisticated, dominant, global consumer company does not have as good a handle on its costs as one would hope.”

Nike is an incredible brand. An icon really. It's down about 20 percent from its 52-week high, but that $115 price was being fueled by a lot of optimism. It's now trading around 20x earnings trailing twelve month earnings. That's not cheap unless we think those earnings are depressed for some reason. A quick view of Morningstar data shows that Nike is actually near an all time earnings  peak.  

For now it's on the watchlist, but I would want to see some more healthy pessimism behind this before saying it's a prime Shleifer Opportunity.

BBBY Entering Shleifer Effect Watchlist

The share price of Bed Bath & Beyond (BBBY) fell over 15 percent today, and this looks like a classic Shleifer Effect Watchlist opportunity.

To net it out, expectations have been building (as we can see from the rising stock price above) for most of 2012. BBBY did pretty well during the economic downturn, and recovered faster than most people expected. In the meantime, they exceeded expectations for revenue and earnings growth, creating a halo effect for the company and its management. And creating even higher expectations.

And now those expectations have been crushed. Why did they miss? I'm not sure exactly, but I am sure that there's an overreaction in play when a company was valued near $18 billion yesterday and only $14.5 billion today despite net sales rising 5.5 percent, comparable store sales increasing three percent, and earnings actually going up 24 percent. But, alas, they missed consensus estimates and provided lower guidance for the next quarter than Mr. Market had hoped. So it tanked.

I've owned BBBY in the past. It's an interesting business - a category killer - though I've had a hard time understanding how they differentiate themselves enough to stop people from buying much of their core merchandise (linens) at Walmart or Target or online. Somehow they keep moving sales forward, due in no small part (I think) to a very permissive attitude toward promotions and returns. 

All that to say, the big drop has my attention, and I'm watching it. I don't count it among the companies that are so high quality (lots of growth, lots of barriers to entry, etc.) that I would buy them on any overreaction drop, but I'll watch to see if another bad news story leads to the kind of overreaction that's just too alluring to pass up. 

Facebook, Henry Blodget & the Shleifer Effect

God bless Henry Blodget and his Business Insider concept. He's taken pieces from the Huffington Post and Gawker models and brought them to business media, a "journalism" market most would say is far too buttoned down for sensational style reporting. 

Well, it turns out business readers are just as big of suckers for tabloid headlines as any other group. I count myself in there, too. I confess to being an avid (perhaps too avid) follower of all Blodget posts on Business Insider. I'm not ashamed of it. The dude is smart and occasionally very insightful. (Following him on Twitter, however, will exhaust you. He can give the best teenage gossip girls a run for their money.) The piece he wrote for New York Magazine about Mark Zuckerberg, The Maturation of the Billionaire Boy-Man, was an impressive specimen of long form journalism. And he went deep on analysis and commentary (here) of Zuckerberg's letter to investors from Facebook's S-1 filing, to the benefit of anyone interested in understanding the CEO's motivations. Finally, he provided a sensible perspective on the whole sham of IPO pops with this article:  Everyone Who Thinks IPO "Pops" Are Good Has Been Brainwashed. 

But you must take Blodget's approach with a grain (or two...or three) of salt. You must recognize that his purpose is to entertain as much (or more so) as it is to inform with a journalist's rigor. Blodget's job is to give his audience that fix of instant analysis, irrespective of whether the facts queue up in a straight line.

Since I bought shares of Facebook (write up here), I've been particularly interested in his coverage there.  It's been a fun ride. Let's do a quick re-cap...

The latest was this story from the afternoon (caps are his): GOOD NEWS FOR FACEBOOK: Big Advertiser Says Performance of New Mobile Ads Is Very Promising. A positive news story, of course. But it's reversing course from his standing trend, as demonstrated by these headlines:

• DEAR FACEBOOK: It's Time To Build A Real Email System (June 14, 2012)
• Here's How Facebook Is Hitting Up Small Companies Who Want To Reach People Who "Like" Them (June 8, 2012) 
• Well, We Just Asked A Bunch Of Big Advertisers What They Think Of Facebook Ads...(June 8, 2012)
• Here's What The Smartest Investor I Know Thinks Will Happen To Facebook Stock (June 1, 2012)
• Here's Another Concern For Facebook Investors--"Payments" Growth May Suddenly Flatten (May 30, 2012)
• If Facebook Really Goes Into The Mobile Hardware Business, Investors Should Run Away Screaming (May 27, 2012)
• BOMBSHELL: Facebook Bankers Secretly Cut Forecasts For Company In Middle Of IPO Roadshow (May 22, 2012)
• GREAT NEWS: Everyone Who Loved Facebook Last Week Can Now Buy It At 10%-15% Less! (May 21, 2012)
• Well, Now That Everyone Has Sobered Up, Let's Figure Out What Facebook Is Actually Worth...(May 21, 2012)
• Well Done, Muppets! Great Job Not Getting Sucked In By The Facebook Hype...(May 18, 2012)
• The 13 Secrets To Facebook's Success (May 17, 2012)
• DEAR GIDDY FACEBOOK IPO BUYERS: Are We Looking At The Same Numbers? (May 16, 2012)  

Blodget is a one man Shleifer Effect machine! In the course of a month he takes us from enthusiast to depressive and back again, spinning the story each time for maximum attention-grabbing affect. That's his spiel, and I don't fault him for it. But I do see his hyperactive approach as a microcosm for what traditional financial media does, just much slower turnaround. Blodget cycles from mania to depression a few times a day, eager for the clicks and agnostic to what might generate them. Traditional financial media works in slower waves, but they're no less captivated by the prevailing mood and only slightly less eager to portray complex issues as absolutely bad or absolutely good.

Facebook (FB): Entering Shleifer Effect Watchlist

I don't believe Facebook requires much by way of introduction. I'm not sure history can show us a more heralded (by the media anyway) public offering fueled by tremendous optimism about the business only to be replaced within days by a string of bad news stories, leading to widespread pessimism about its future, and accompanied by a steep drop.

This is classic Shleifer Effect stuff. But it's a different kind of business than ones I'm used to evaluating and owning...it's a far cry from a value situation. This is classic big story growth stock. That's why I have to disclose this confession: I bought a small piece of this business today.

I'm working on some other projects and don't have the time to go into much detail right now, but I'll try to get back to it soon. 

Suffice it to say that I see a business with a lot of opportunity for growth by tapping an asset of enormous value, its user base. They make some money now, and I believe the company will find ways to squeeze something viable (nay, thriving) out of those 900 or so million users.

While I remain skittish of social networking businesses (see this post where I mention Facebook in reference to MySpace), I believe there is a durable competitive advantage. In other words, I don't foresee (despite many people that believe differently) something like Twitter or an upstart making serious inroads to steal Facebook market share and/or force it into a pricing war that reduces its profitability. 

I also believe it has a profitable economic model in that its gross margins can (and do) exceed its expense structure (and this despite a lot of expenses expanding for growth) and its earnings can (and do) exceed its requirements for reinvested capital.

But then there's that pesky problem of price. When measuring it against earnings, it's high. Very high. Even after the major fall. How am I rationalizing this to myself then, you must ask.

Pessimism. Tremendous, and I believe, unwarranted pessimism that is leading to irrational behavior. Granted, this same pessimism could burgeon further from here. My purchase might lose value. At this point, based on my evaluation of what I see, that would create another buying opportunity. I would take advantage of it.

So, I will no doubt inspire righteous ire by quoting Warren Buffett below in my justification for buying Facebook. But these models are complex and nuanced, so here is one upon which I'm depending more and more...

“The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

–Warren Buffett, 1990 Letter to Shareholders (found via A Few Lessons for Investors and Managers)

Most of the resources I'm paying attention to for news about Facebook come from Henry Blodget's BusinessInsider.com. Again, I'm not actively trying to attract the outrage of my value investing compatriots, but I find a lot of signal inside the layer upon layer of noise that comes out of Business Insider.

Facebook Stock Is Breaking Down Again (May 30, 2012)

How Morgan Stanley Clients Got Screwed On Facebook -- And How We Can Fix The System (May 31, 2012)

Lowe's (LOW): Entering Shleifer Effect Watchlist

Some Background

Last November I spent a little time looking at Lowe's, an interest generated by a "follow-the-leader" mentality. Bill Ackman of Pershing Capital made a detailed presentation at the Ira Sohn Conference in which he made a compelling case for Lowe's as undervalued, as quickly improving shareholder value by buying back shares, and as protected from the threat of internet encroachment on its business (aka, Amazon.com) by virtue of the type of products its sells. (You can access the presentation here.)

At the time I made my own stab at trying to understand its owner earnings (see here for a description of what I mean by that) and applied a conservative approach to valuing the business. I assumed it had somewhat depressed earnings based on the housing market crunch from the last few years, and I projected that a slow recovery over the next few years would lend itself to owner earnings improving an average of ten percent per year over the next five years. I further assumed the share count would drop from 1.4 billion to 968 million over the five years, for a total of $10 billion used for buy backs (versus the $18 billion Lowe's has allocated). And the dividend would grow at a rate that basically mirrored the growth in owner earnings. 

The price then was about $20 per share. I thought it needed to be around $17 to satisfy my requirement for a clear and conservative path to realizing 15 percent compounded gains over a five year period. Lowe's proceeded to rocket over the next few months, going as high as $32. It didn't hurt having Ackman on board.

I did not invest.

Entering Shleifer Effect Watchlist


In the words of the chartists, Lowe's "gapped down" on news of its Q1 sales and earnings this Monday. (The press release is here.) It dropped more than ten percent, earning it a spot among the biggest price losers of the day...and earning it attention for the Shleifer Effect Watchlist.

Wall Street had been building higher expectations, pegging Lowe's as a bellwether for whether the housing market is improving. They get excited by Lowe's and Home Depot when sales are improving, and they get depressed at any signs of deterioration. That dynamic lends itself to volatility and (hopefully) opportunity.

I've added "Market Mood" as a new designation on the Shleifer Effect Watchlist. The concept is predicated on investors being either overly optimistic or overly pessimistic about a business' prospects, overreacting to a string of news events suggesting a trend pointing one direction or the other. If the mood is optimistic and multiple negative events happen, there is a good chance of overreaction on the downside. Conversely, a pessimistic mood followed by more bad news might not create a price shock, but - if the price doesn't move much more at bad news - it could signal the skittish investors have jumped ship, setting the stage for better things to come.

I think it's fair to say the overall mood is on Lowe's is fairly pessimistic, but there were greenshoots of optimism. (Do I sound like an economic forecaster?)

The earnings on Monday represent just one bad news event. The reaction was strong. But I'm willing to hold off an investment until/unless there's another piece of bad news. That could create a strong buying opportunity.

Ackman Thoughts

I should note that Bill Ackman was not long for his Lowe's investment. According to 13-F filings (reported here), the longest he might have held it was six months. But it could have been much less time. He told CNBC (here) that he sold to take advantage of the quick rise in price and then took the gains over to his better idea...Canadian Pacific, the railroad company.

For those tempted to follow the gurus in a blind manner, let this be a lesson...you'll never fully  know their thesis or timeline for holding something. Make your own decisions. Make sure you have conviction behind your bets. 

The Investments Blog

Finally, Adam at The Investments Blog provided an excellent investment thesis for Lowe's back in June 2011.  It belongs to his Six Stock Portfolio, a concept he started in 2009 with several high ROIC businesses that were trading at fair-to-depressed prices. His bet is that by purchasing these stocks (Diageo, American Express, Wells Fargo, Lowe's, Pepsi, and Philip Morris International) at a time when the market wasn't so enthusiastic about them, the reasonable purchase price plus competitive qualities of the franchises promised a very satisfactory return over extended periods of three years to...well, forever. His results (as you can see here) have been impressive.

You can read Adam's Lowe's thoughts at Lowe's Shareholder-Friendly Buyback Plan. 

Update on the Shleifer Effect (WMT,INTU)

Earnings season is hunting time for the Shleifer Effect and provides the most concrete "new news" updates to track the progress of targets already on the Watchlist.

Shleifer Effect Concept Summed Up

The Shleifer Effect is rooted in the social psychology concepts of representativeness, conservativeness, and overreaction as highlighted in Andrei Shleifer's book Inefficient Markets: An Introduction to Behavioral Finance. (I introduced the construct here in the context of evaluating Aeropostale (ARO) as an investment opportunity.)

In a nutshell, Professor Shleifer describes how investors have a tendency to interpret a series of events as a pattern that will continue in the future (representativeness); once they believe a pattern is in effect, they stick to their view until multiple instances of "new news" suggest a new pattern has taken hold (conservativeness); at which time they tend to pull an about face, believing the new pattern will persist into the future, and make their investment bets in dramatic fashion according to the new news (overreaction).

Together, these behaviors create the Shleifer Effect whereby investors overreact to news sending the price of some stocks soaring above and some stocks plummeting below any reasonable assessment of their intrinsic long-term value.  These tendencies create opportunities for investors who pay attention and are ready to take advantage of the thinking "glitch." We're most interested in overreaction on the down side creating buying opportunities in high quality businesses.

Tweaking the Concept - Introducing Salience

Walmart and Intuit both reversed previous announcements of bad news with an instance of good news. This creates an interesting question for how we manage the Shleifer Effect Watchlist. If the company manages to sidestep multiple instances of bad news (multiple being the theoretical requirement needed to produce investor belief in a new trend and thereby force an overreaction), does that mean they fall off the list altogether?

My gut reaction is "no." I'll suggest that existing owners are taking a wait and see approach. For Walmart in particular, the older bad news came from the NY Times story about bribery scandal allegations in its Mexico operations (featured here). The stock took a five percent hit the day after the story broke. The repercussions of that story are still unfolding and will likely take years before the full affect is known. I think it's fair to consider it to be on its own overreaction track. A separate track, I suspect, from a larger earnings representativeness bias that was in process and taking a higher priority in the minds of investors...namely, the challenge with same store sales in the US and its depressing impact on overall corporate earnings.

The latest earnings news (the press release is here) arrested the down trend by showing growing earnings, beating analyst expectations, and (most importantly, I think) the growth coming on the back of 2.6 percent growth in US stores.

In terms of tweaking the concept, I'll hypothesize that there's an element of salience to be considered here. In other words, the Mexico bribery scandal grabbed a lot of headlines. Some investors reacted by selling their shares. But its salience to the base of most existing investors was not very high. They didn't consider as an event significant enough to affect the earnings power of the business. And that - the earnings power of Walmart - is the most important issue to investors. The story with the most influence on earnings (therefore most salient) is the sales performance of US stores.

So, when the latest report shows an improvement in US store performance, the Mexico story loses its punch as it applies to the Shleifer Effect. The Walmart Shleifer Effect is temporarily suspended. Since putting Walmart on the list, it's up over six percent. If the report had been negative, I believe there would have been a compounding result. The belief in a trend of US stores being in overall decline would become stronger. The conservativeness bias as Walmart being a "has-been" retailer would strengthen. And this would have built on the Mexico scandal, sending investors into a selling overreaction.

I'll keep Walmart on the Watchlist for now with zero occurences of bad news. The next potential for Shleifer Effect news seems to be the annual meeting, scheduled for Friday, June 1, 2012 (information here).

That's my current thinking anyway. The whole Shleifer Effect is a construct-in-progress, so give me the freedom to shoot a bit from the hip while I figure out how it works in this live fire Watchlist environment.

On to Intuit (the initial post was located here). On April 20, 2012 Intuit made an announcement suggesting that third quarter earnings might fall below Wall Street expectations because of the digital tax prep category under-performing slightly. That's caused the stock to fall about six percent.

Last week it changed the course, reporting that - despite the impact of digital tax prep - Q3 was quite good and management is optimistic enough to increase its guidance for earnings performance for the full fiscal year 2012. (That release is here.) The stock has recovered somewhat, but still sits just below its price at the initial write-up. 

With that, I'm suspending Intuit from the Shleifer Effect Watchlist. The two stories off-set each other, and I don't see any momentum right now toward investors believing a new negative trend is developing. It falls back into its previous mode, in which investors expect it to continue growing at a nice clip and are content with it sporting a 20+ P/E ratio. 

I'll keep tracking it on the list, but we're putting it back to square one with ZERO occurrences of bad news. 

H&R Block (HRB): Entering Shleifer Effect Watchlist

H&R Block (HRB) was slammed this morning after announcing a strategic realignment, using the same press release (here) to announce it also expects fiscal 2012 revenue and earnings to be in line with analyst estimates. The news was a tacit admission that its current approach of offering its services with storefronts and software is far from optimized. With a 13 percent price drop, HRB now sports a P/E around 12 and a dividend yield over five percent.  The dividend looks sustainable from current levels of operating cash flow.

My quick impressions of HRB is that it is a much despised stock with a relatively new management team attempting to escape the reputation established by their predecessors. The business also has a sullied reputation given its long association with tax refund anticipation loans (a practice akin to issuing usurious payday advance loans). Without question, it is in turnaround mode. Its business peaked in 2004 when it generated over $1 billion in operating income, but it was not able to sustain that level of earnings. Earnings have been pretty bumpy ever since. 

This appears to be the first piece of first-order bad news in some time.

Well, we're adding HRB to the Shleifer Watchlist. The next big piece of news seems to be Q4 and FY 2012 earnings announcement that is scheduled for June 26 (see the calendar here). We'll watch with anticipation and try to spend some more time with the business beforehand in case it an overreaction opportunity presents itself.

Walmart (WMT): More Thoughts on NY Times Allegations

As considered here, the allegations of Walmart violating the US Foreign Corrupt Practices Act (FCPA) presents an interesting opportunity to watch the Shleifer Effect in play. 

It's about three days since the news broke. The market reaction has remained pretty tame with Walmart down about 6.5 percent (to about $58) from its Friday close. True, that's $15 or so billion in value disappeared, but that's for a company sporting a $200+ billion market cap. And while it puts WMT near its lows for this calendar year, let's remember that Mr. Market was pretty down on the business just several months ago when it traded below $50 per share. A 6.5 percent drop is big for a single day, but it's not beyond the sort of fluctuating price range most fundamental investors might expect from Mr. Market's typical fickleness.  Per the Shleifer Effect, it doesn't seem to indicate a wholesale change in the way most investors view the business. In other words, it would be hard to argue that the news has stoked an overreaction bias.

When considering the Shleifer Effect, not all news is created equal. Let's say there are two categories of news. You have first order news, the kind that suggests to owners that their thesis for investing might be wrong and a new (negative) trend might be taking hold. This information might say that sales are slipping or expenses increasing or the market is not as strong as hoped or competition has an edge...basically, anything that gives the investor reason to believe the earnings trend points down instead of up. 

First order news is more likely to generate a change in "conservativeness bias", creating a belief in a new trend taking hold, and instigating an overreaction.

I would suggest that first order news is either a.) a story or piece of information that gives the market sufficient reason to believe that earnings will be affected or,  b.) earnings themselves coming in below expectations.

Then there is second order news. While this might be salacious or disturbing, it's ambiguous about how or whether it affects the actual prospects of the business. Investors take notice of it, but they don't necessarily change their views on the prospects of the business itself.

The NY Times story seems to be second order news when it comes to the Shleifer Effect. It has certainly grabbed people's attention, but the market response (so far) suggests investors are willing to wait to see whether the alleged FCPA violations actually affect Walmart's business fundamentals in a meaningful way.

*****

As a current investor, my initial thoughts on the potential impact of the news are as follows (in order of magnitude):

1. Walmart's International Growth Suffers

Not only will corporate management become entangled in the legal and PR aspects of managing this crisis, but the in-the-trenches guys will be considering their own practices in a different light.

As suggested in this Business Week article (here), Walmart has relied heavily on its international division to produce earnings growth while US performance has been sluggish for a few years. I can easily see a scenario in which international managers go into CYA mode, becoming so conservative in their business practices that they sacrifice growth opportunities. 

Let's hope that the Mexico thing represents the extreme version of international managers pushing the envelope in the name of growth. But I have no doubt that plenty of other managers are aggressive, stepping deep into the gray zone of ethics as they attempt to hit ambitious expansion targets. 

I think it's reasonable to expect that executives throughout the corporation perform a quick review and start slashing practices that might attract any attention from investigators that start poking around, no matter if they're illegal...if it's in the gray zone, it's out. This could affect the number of new store openings, a critical driver of growth.

I don't think we would know anything more about this until we read Walmart's announcements on the performance of its various divisions. So, we wait and see...

2. Walmart's Senior Management Goes Through Widespread Shake-Up

The NY Times article claims that many of Walmart's senior executives were made aware of the activities in Mexico and elected to cover up the problem rather than self-report to the Department of Justice.  It implies CEO Mike Duke, who had management responsibilities over Mexico operations in his role at the time, was briefed on the violations. 

(Somehow Doug MacMillon, current CEO of Walmart International, escaped mention in the article. That's a little baffling especially given his rising star within the company.)

If true, it's hard to see the current regime of executives surviving the investigation. Walmart is under the firm control of the Walton children (who have nearly 50 percent ownership and much more say than all other investors), and I don't see them allowing a wide assault on the reputation of their business without going to the bench to promote a new group of managers.

Expect a shake-up with ensuing disruption. While I'm inclined to want continuity in operations and management (give their strategies a chance to develop), I suspect the Waltons and other investors would not be heart-broken to see the current regime leave. Their performance has not exactly been stellar, most notably when it comes to U.S. same store sales growth, a division that Eduardo Castro-Wright attempted to overhaul after he was promoted from Mexico to run the U.S. (Castro-Wright failed in this attempt and was demoted in 2010 in favor of Bill Simon.) 

The shake-up would likely create optimism for the stock provided Walmart has the right managers in waiting that are both immunized from the scandal and capable up stepping-up.  

3. Walmart Is Punished and Subjected to Historic FCPA Violation Fines

Here is the area where we can expect the greatest speculation. Business Insider has already put together a scenario (here) in which Walmart would have to pay out a fine in excess of $13 billion. 

I have no relevant experience here to make even an educated guess at how this plays out with the DOJ. But I'll try anyway. 

I think it's fair to assume that politics will get nasty and regulators will look for their pound of flesh, hoping to make an example out of Walmart. That being said, it's worth noting that the biggest penalty to date under FCPA has come from Siemen's AG at $1.6 billion. Perhaps Walmart would end up paying higher fines, but I would suspect the DOJ would get what it could and not risk trying to extract such a high penalty that it risks Walmart goes nuclear in fighting back. Would DOJ risk going for something too high and watching Walmart choose litigation over settlement? I would assume they are reasonable and get the guaranteed money for the US Treasury.

Still, what's the effect? First, the process is likely to take a long time (as noted below by Mike Koehler of FCPA Professor in his thoughts here on what we might expect for Walmart's near future as a result of these allegations): 

...the information revealed in the Times article is likely to be a long and costly exercise for Wal-Mart and certain of its executives. Wal-Mart’s statement over the weekend indicated that it already is conducting a world-wide review of its operations and such “where else” investigations frequently uncover additional problematic conduct...This world-wide review will take time and for this reason FCPA scrutiny of the type that Wal-Mart is currently under is likely to last 2-4 years. 

Second, the fine will be a one-time thing. With Walmart losing $15 billion in market value, one could easily argue that investors have already accounted for its penalty (and then some). That's wishful thinking, of course. But with $24 billion in net cash provided by operations last year, we can feel safe that even a large penalty doesn't threaten the ongoing health of Walmart.

It's hard to imagine that a one-time event that might happen two or more years in the future can be properly discounted now. However, when expectations about its price tag get more settled, it is the sort of thing that could create a short-term hit to Walmart's price. We'll watch it then.

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And so we call the NY Times story second order news. It puts everyone on alert, and it probably means most investors will be paying a lot more attention to Walmart's earnings announcement over the next several months to see how/if the Mexico scandal is bleeding into operations in a broader way. 

We will continue thinking about our own investment in WMT, watching those earnings carefully to see if they produce a Shleifer Effect overreaction and create another buying opportunity for long-term investors.

Walmart (WMT): Shleifer Effect Watchlist

Yesterday's NY Times reported here that Walmart employees have spent years bribing Mexican government officials to speed approvals to build new stores. If true, this would be in violation of the US Foreign Corrupt Practices Act (FCPA). Worse yet, the article claims senior Walmart executives (up to, and including, then CEO - and current board member - Lee Scott and then CEO of Walmart International - and current head honcho - Mike Duke and then CEO of Walmart de Mexico - and current, albeit outgoing, corporate Vice-Chairman Eduardo Castro-Wright) had been made aware of the practice and elected to treat it as an internal matter for its Mexican subsidiary to manage. In effect, they covered it up.

It's fair to assume that Walmart is in for a tumultuous months and potentially years of news reports. 

I own shares of Walmart, beginning my position in March 2011 and building it at an average price around $50. Be assured that I'm watching these events unfold with much anticipation both as an investor in the company and also as an observer fascinated by the dynamics this news will likely instigate. It's a fascinating test for the Shleifer Effect as a construct. 

Though I own it now, the current news warrants looking at it anew. Does it create price movement that overreacts to reasonably considered estimates of what happens to Walmart's fundamental business in the near future? Therefore, I'm adding it to the Shleifer Watchlist.

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Let's start with the immediate market reaction to the news. The finviz.com chart below shows a fairly muted response. WMT started trading about five percent down at today's opening. 

I wouldn't read too much into the first blush. Walmart has not exactly been the Wall Street darling over the past ten years. The stock has moved sideways for a decade, and over the past two years it has repeatedly reported earnings and growth below consensus estimates. Comparable US store sales have been a particular thorny point.  (See Sideways Action Deflates the Value Balloon.) To be blunt, expectations for Walmart have not been particularly high. While it traded as high as 40x its owner earnings in 2003, my last estimate had the current price sporting a 10x 2011 owner earnings. So, despite its 20+ percent rise since I purchased it, Walmart did not enter this PR crisis burdened with lofty expectations of its future.

So what we didn't see this morning was an absolute panic. I suspect that's because current owners might be the type that pay a bit more attention to the fundamental business of an investment. They didn't buy Walmart as a hot stock idea. They bought into the idea of the dominant retailer growing its earnings at an acceptable pace and using its tremendous cash flows to repurchase a lot of shares and continue paying a big dividend. 

If I'm correct, these investors will be assessing whether or not this news has impaired Walmart's ability to continue doing those things. They are, perhaps, spending some time trying to understand the ramifications of the news...specifically, what it means for Walmart's ability to keep generating cash to use for investor benefit.

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Let's count this as a quick few thoughts to initiate Walmart on the Shleifer Effect watchlist. I'll spend some more time with it soon thinking through what it means to own shares of the company now and how that affects my decision whether to invest further if the price drops below the level where I've purchased WMT over the past year.

Stay tuned...

Pricing Power Part I: Apple (AAPL) Demands a Premium

There are two forms of pricing power: the ability to raise prices and the ability to lower prices. The following is the first of a (two part? three part) series on pricing power as a competitive business advantage. 

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The ability to raise prices for your offerings, or demanding a premium over competitive products based on some perceived superiority of your offering, is an excellent indication that your business offers some form of competitive advantage. If you sell clothing, you must be appealing to some fashion sensibility. If you peddle electronic devices, your technology must address some consumer want. 

Having the ability to charge high prices can be very nice. Of course you must ask WHY you can charge the high price and whether the cause is defensible and durable for the long-term...or whether it's fleeting and likely to dissipate with time.

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I can't stop thinking about Apple (AAPL) as an example. It is the clear leader in consumer electronics. It has created beautiful products with elegant simplicity and the content ecosystem that gives users reason to keep on using. It is a beloved brand. Iconic even. So it is no surprise that Apple charges a tremendous premium for its products and does so unflinchingly.

Apple rolls out innovation after innovation. One can easily be lulled into believing that this string of successes portends a trend that will go far into the future, that each new cycle of the iPhone and iPad will demonstrate another "wow!" and send consumers running to Apple stores to secure their upgrade.

But what happens if Apple disappoints? Sustained innovation - staying at the lead of this pack - is very, VERY difficult. Expectations are incredibly high (Shleifer Effect anyone?). Competitors are emulating the technology and it would seem they're narrowing Apple's lead with each product cycle.

And the competitors are eager to charge a lower price. Think Amazon. Think about selling Kindle Fire at a loss. Think of Kindle Fire getting just a little bit closer to the iPad with each new generation. Think how Amazon offers an equivalent content ecosystem to keep users using...but often at a cheaper price. Think how difficult it will be to get price sensitive consumers to justify paying that premium as Kindle Fire gets better and better. 

Apple will just lower its price, you might argue. Or it will offer a scaled back set of devices to compete with Amazon. They have plenty of margin to give and still be plenty profitable. Right?

Perhaps. but what does Apple lose in the process? Certainly the high ground of being a premium-only device provider; one that refuses to sacrifice quality; one that seeks the sublime in its designs. That is the sacrosanct brand of Apple, that which Steve Jobs dedicated a life to creating.  Changing it would be a substantial change to the culture of the company.  Indeed, a big change to its image of itself.

Were it to accept lower margins for its products, it also presents a revised economic model to its investors. Can we imagine investors reacting well to a product line with lower margins that likely cannibalizes its much more profitable existing product line? That certainly changes the earnings profile of the business.  One might easily argue that such a move would create additional new unit sales for Apple, generating more revenue by bringing in the price sensitive buyers who want iPods and iPads and iPhones but cannot afford them today. Perhaps. That is a plausible scenario. But I suspect that Apple will have a hard time dumbing down its products enough to make them price competitive with Kindles. This just goes against the DNA passed down from Jobs. And if Amazon is willing to sell Kindles at break-even or lower...

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I suspect that Apple has painted itself into a corner. In no way is that comment meant to denigrate the company...its achievements are extraordinary; its products are remarkable. But from a competitive perspective and an investor perspective, I think it has a tough trail in front of it. I mean...

Customers have sky high expectations that each new release will make strides over the last. Apple must continue its track record of innovation (which is probably unmatched in the annals of consumer electronics) in perpetuity (or at the very least, only allow minor setbacks) to satisfy those high expectations.

This while carrying the banner of lead innovator, holding it high and proud for all the competition to see. This is hard! It's like holding the lead at the Tour de France. You cut into the wind for everyone behind you. They get the benefit of drafting. They can watch your every design move, tear apart each new release to learn how you did it, study your supply chain tactics...emulate your every move and pull closer to you with each cycle. 

That banner of innovation, and that grinding into the wind, gets harder and harder the longer you do it! The peloton drags you back in.

Finally, whether it comes from a lapse in innovation for a new product release or the decision to cut margins by moving downstream with a "value" product, earnings will suffer. And investors DO NOT suffer declining earnings happily. 

In light of how the market rewards Apples long string of record-breaking earnings - by giving it a multiple around 16 times its trailing results at a time when they should be at the height of their optimism - one must ask how investors react if these earnings slow down or shrink. (Actually, for the sake of the Shleifer Effect, it could present a good investing opportunity!)

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So Apple is my example of a firm able to raise prices and/or charge a big premium. At the outset I suggest that we must inquire whether the advantage(s) that gives the company the ability to charge a premium is defensible and enduring. We must understand this in assessing the strength of its competitive advantage. 

I believe Apple's is based on continuous superior innovation leading to excellent products and brand cachet. If the innovation slips, its reputation becomes scarred and competitors will step in on short notice to fill any breech. And innovation is hard. What Apple has done to date is extraordinary. But at some point do the pressures cause them to revert to a mean? At some point, do they tire and stumble? Perhaps not. But I wouldn't bet on it.

Intuit (INTU): Entering Shleifer Effect Watchlist

Intuit, developer of Quickbooks, TurboTax and Mint.com, announced today that its revenue might meet or fall below Wall Street expectations. Shares fell nearly five percent. (See a brief write-up from Bloomberg here and Intuit's release here.)

The Finviz.com chart below shows that the drop is big as a one-day event, but investors have demonstrated a lot of optimism about the company's prospects over the past year as the price has appreciated about 50 percent. As I posted yesterday, it's a dangerous thing to buy in on optimism.

I'll hold off on any analysis now and wait for the actual earnings announcement due in about a month. If we get more news that the investment community interprets as bad, perhaps we'll have a live one to pursue. For now, it's on the watchlist.

No Extra Credit for Being a Contrarian

I'll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham's bi-polar Mr. Market, Sir John Templeton's suggestion to buy when there's blood in the streets, and even from Joel Greenblatt's magic formula for spotting strong businesses that are out of favor. 

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It's a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It's an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn't mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you'll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news. 

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We're looking for companies operating good businesses that happen to be misunderstood or unpopular.  

There is no extra credit for being contrarian. You must be right! 

“The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

–Warren Buffett, 1990 Letter to Shareholders (found via A Few Lessons for Investors and Managers)

Mattel (MAT): Entering Shleifer Effect Watchlist

The NY Times headline sums it up...In Season of Slow Toy Sales, Mattel’s Profit Plunges 53%. From that article...

Mattel said Monday that its first-quarter profit dropped 53 percent, pulled down by costs tied to an acquisition and lower sales for Barbie and Hot Wheels.

Results were below expectations and its shares fell more than 9 percent. But the disappointing results came in what is typically a slow time for toy sales, so Mattel executives said they remained optimistic.

This is the first real earnings miss or piece of bad news that has the potential for making a big impact on the way investors view the business. It's only a notice to pay attention, not a call to action. 

What are the potential outcomes? 

One, the business improves its results next quarter (or with some interim reporting period), investors cling to their previous view of the business (conservativeness heuristic), and the price stabilizes.

Two, the business reports another one or two periods of earnings trouble, investors change their view of the businesses future (a new representativeness heuristic) deciding that it's now in a down trend, and they overreact by selling off its shares...creating an opportunity to buy the business at a price below a reasonable estimate of its intrinsic value.

And the finviz.com chart below shows the sell-off yesterday. The nine percent drop is significant as a one day decline on high volume. But the price investors are willing to pay for the stock has been heading up for several months now. There has been a sense of optimism about Mattel's future.

Some Thoughts On the Toy Business Model - Dependence on Blockbusters

I spent some time with Mattel and Hasbro in a few posts in January 2012 (here). I never completed the valuation of Hasbro (sorry), but the research highlighted some key characteristic of the toy industry. 

Toy sales are pretty volatile. Mattel and Hasbro have several brands they own outright. Mattel has Barbie, American Girl dolls, Hot Wheels, etc. Sales from these brands tend to be somewhat stable, smoothing out the ups and downs from the huge chunk of their business that depends on licensing entertainment-based brands. 

Here are a few big things to keep in mind about the entertainment brands...

One, there are not very many big ones out there. The biggies are Sesame Street, Star Wars, Marvel Comics, etc. They are very valuable to the intellectual property owners who want licensing partners that will generate a lot of revenue for them, obviously. 

Two, Hasbro and Mattel must bid against each other for the rights to make and sell toys based on the big brands. They pay guaranteed money and a portion of each revenue dollar to the brand owners. Their eagerness to win rights to the big brands creates an epidemic of the winner's curse in which there is a tendency to overpay in order to beat out your rival. Hasbro had a big problem with this several years ago after winning the Star Wars contract. Lucas Ltd. demanded major dollars upfront. Hasbro paid and then saw the popularity of Star Wars toys go on the decline as movie after movie saturated demand. They took a hit. 

Three, and this is the most important trait of the toy business to understand, the blockbuster element of toy sales creates peaks and valleys in sales and earnings. Sales and earnings don't creep onwards and upwards to a steady drumbeat. When a big movie hits, toys associated with that movie spike. Kids are fickle and tend to buy (rather, their parents and grandparents buy for them) the most popular items that all the other kids are buying. The toy companies must anticipate demand, design the right toys, and get them into retail channels in tight coordination with the movie release. So, when Transformers movies come out, Hasbro tends to kill it (especially since, in this case, they own that brand outright and don't have to pay licensing royalties). They'll sell a hundred million in a year. But then the brand popularity wanes when the movie goes away, and if Hasbro can't find something to replace it...sales and earnings tank the following year. 

The Shleifer Opportunity

And so here we are with Mattel showing a 50 percent drop on earnings over last year as Barbie (its own brand) shows weakness. This is not the first time...it won't be the last time. It creates a trailing P/E of 14 after the nine percent drop in the stock price yesterday. Is that cheap? 

Doubtful. 

I'll add this to the Shleifer Effect watchlist, but given the volatility of the toy business I'll require two things to take Mattel seriously as in investment. 

First, it must drop significantly below its current price. Therefore, it's going to need more bad earnings reports to create the overreaction bias necessary to get investors selling.

Second, based on a price driven down by overreaction, I must see a clear and conservative path for Mattel earning profits that would easily exceed depressed expectations over the next few years. 

To be very clear, Mattel would not be a long-term holding for my portfolio. If the right confluence of events happen to justify an investment, it would be based on a tremendously cheap price that bakes in low expectations for future performance that Mattel would have little trouble exceeding based on conservative assumptions. I would sell after a new optimistic representativeness heuristic set in, causing overreaction to the upside. 

The Shleifer Effect Watchlist

Over the past few weeks I've begun working on some screens to help identify businesses experiencing some element of what I've come to call the "Shleifer Effect." In short, these are companies that have produced a string of results below investor and/or market expectations. The impact is a shift in current owners' expectations for future results (i.e., the trend will continue and the future will look like a worse version of the present) which produces an OVERREACTION in the form of a heavy sell-off and price drop. 

I'm really looking for two things. 

First, if I can uncover opportunities where the Shleifer Effect is already in play, that's the best. This is where the bad news is out in the open and the price has already been hammered over successive earnings reports. The overreaction had already set in and current investors have either stuck with it despite all the bad news (true long-term owners), or they've purchased their shares with the bad news in the open which potentially moderates their expectations of upcoming results.

Second, I'm trying to identify opportunities with developing Shleifer Effects. In other words, there is initial bad news/results but not yet enough to change investors' perception of the business and create an overreaction. I'll watch these to see how the market reacts as one earnings miss turns into two...three...four.

An important note: though these descriptions, and the use of charts, makes this seem like technical analysis, this is not really about timing a bottom. I'm still looking for good or great businesses whose models I understand (or can learn quickly) and whose economics are usually relatively stable...just not at the moment.  My ideal is to find an excellent business (a la Amazon.com, Costco, etc.) with clear competitive advantages and buy them as long-term holdings when the market punishes them for short-term outcomes. But I'm also open to investing in decent businesses (see Aeropostale) as medium-term (up to five years) when investors have overreacted in such a way that I can see a clear and conservative path to 15 percent annual returns with very little risk.

As discussed in this previous post about Thomson Reuters, using the Shleifer Effect as an investment screening strategy is about, as much as anything, interpretation arbitrage opportunities that can lead to time arbitrage opportunities.*

So, with that, I'll begin tracking existing and developing Shleifer Effect investment opportunities here. There is also a link on the blog homepage to see the spreadsheet.

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*From the Thomson Reuters post referenced above:

Interpretation Arbitrage: Investors have interpreted declining earnings - and the resulting earnings misses - as bad news and reacted accordingly by changing their opinions on the firm's future and selling off shares. They've misinterpreted the financial information or news, creating an "interpretation arbitrage" opportunity.

Sometimes the EPS miss does not represent a change in the company's prospects. It can be random. It can be part of the grittiness of operating a business where you're just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow.

Time Arbitrage: Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings.

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.