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. 

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.

*****

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.

*****

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.

*****

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...

Amazon (AMZN): Playing Offense or Defense? Part A. Subsidized Shipping

Reported Earnings Overstated - The Impact of Restricted Earnings
Owner earnings are those that can be extracted from the company for the benefit of shareholders (dividends, buybacks, debt reduction), plowed back into the business to create even greater earnings in the future (growth capex, investments in expense infrastructure, acquisitions, etc.) or held as surplus cash. They are "unrestricted" in that management has significant discretion on how to use them without damaging the current earnings ability of the business. 

Reported (GAAP) earnings do not discriminate between the portion of earnings that are unrestricted and the portion ("restricted") that management has no option but to plow back into the business just to keep things current. Examples are replacing obsolete equipment, refreshing old stores, responding to a competitor's pricing tactics, or ramping up customer service because clients are threatening to leave without it. They are all necessary investments, but they don't create incremental earnings. At best, they prevent the erosion of existing profits. 

Reinvestment of the restricted portion of earnings creates the unpleasant sensation of running to stand still. You can expend a lot of energy without taking the business anywhere. 

You won't find a line on the income statement called restricted earnings. As Buffett said in his 1986 letter to shareholders, determining which portion of earnings are unrestricted versus which are unrestricted is tricky. Indeed, it's quite different from industry to industry. For a manufacturer in a highly competitive market, a large chunk of its reported earnings may not be available to reinvest for growth or to pay out to owners. Why not? Because every five years it must spend tens of millions to retool factory assembly lines to accommodate new designs, to engineer more efficient production techniques, or to begin construction of new products that replace obsolete models.   

Reported Earnings Understated - Making "Productive" Investments in Expense Infrastructure

But the idea can cut both ways. Most businesses will report earnings that exceed the actual dollars available to benefit owners. But some businesses (particularly those in growth mode) will report earnings that dramatically understate the amount of cash being plowed back to grow future earnings ability.  For example, they may report $1 million earnings but in reality they plowed $10 million into marketing to acquire new customers that will produce more earnings power in the future. That is certainly the case with GEICO that Tom Russo talked about at the Value Investing Congress last year (and which we discussed here).  

In that scenario, do we value the business based on the $1 million in reported earnings? Or do we value it based on the $11 million it would have generated if not for the investment in acquiring more customers?

Well - no surprise here - it depends.

The dilemma is that we don't want to use this idea to rationalize investments by bloating the target company's earnings. It can be a slippery slope...you can argue with yourself to exhaustion trying to justify buying a company with a great growth story at its current high price-to-earnings ratio. One must err on the side of caution.

When considering this sort of situation, the first filter I might apply to the decision is how confident you can be that the increased expenses that lead to lower reported earnings are actually investments with the high likelihood of paying off in the future. And in this thought process, apply a high burden of proof on the company. One is wise to evoke the wisdom of Richard Feynman...The first principle is you must not fool yourself, and you are the easiest person to fool.

Another useful filter is to ask whether the increased spending (or whatever caused the reduced earnings) comes from the company playing offense or playing defense. This is important. Is the increased spending a result of the business understanding its competitive advantage and investing heavily in it? Or is it a reaction to a competitive move in the industry where, if the company doesn't respond, its business is harmed? 

In the former, it's likely (though not conclusive) that the company is spending in a manner that creates future value for shareholders (again, like the GEICO example) even if it reduces reported earnings today. It's fair to consider those investments as unrestricted earnings and count them among owner earnings when valuing the business.

In the case of the latter, the defensive spending, I would argue that this is likely an example of restricted earnings that are rightfully withheld from reported earnings.  

Amazon.com: Increasing Spend = Offense or Defense?

Let's bring this back to Amazon. The business clearly operates in a market with growing demand for its products and services. Year-in and year-out, Bezos et al must make educated guesses about consumer demand one-, two-, three-plus years in the future and invest in their infrastructure accordingly. Sure, they could stop those investments today by declaring their wish to optimize throughput of existing assets, pushing more sales across existing infrastructure (fulfillment centers, technology, marketing efforts, personnel, etc.) and probably create sizable profits for investors. But that would be choking the golden goose, seriously affecting its ability to lay more golden eggs in the future. Instead they build out in anticipation of what's to come.

Here are several categories of that type of investing...were they offensive or defensive in nature?

A. Subsidized shipping to pull more shoppers to the web and away from traditional retail.

In the beginning, Amazon treated shipping as a source of income. Later, its goal was making shipping a break-even proposition. Now, the company proudly uses shipping as a loss-leader, accepting the glad trade-off that quick-and-cheap shipping translates into wider consumption from customers who would otherwise give the business to Target or Best Buy.

From 2010 to 2011 Amazon plowed $1.1 billion into subsidized shipping, increasing its net shipping costs 76 percent...far above the additional shipping revenue that came in with 41 percent overall sales growth.

Should we expect this to change? No. This is the ultimate offensive move in two ways.

First, consumers are quick to tally shipping charges into the total bill when comparing costs of buying online versus bricks-and-mortar. Amazon recognizes that much of its growth will come from prying shoppers from trips to Wal-Mart and the mall. One way to achieve this is to provide a lower "landed" price than what they would get when getting in the car to shop with competitors. Shipping is part of that landed price, and Amazon is willing to invest in making it cheaper and cheaper for buyers.

It's important to note that shipping is included in Amazon's overall cost of sales calculations. In 2011, COS was about 78 percent of revenue. For Wal-Mart, COS was about 76 percent of revenue...and Wal-Mart has a tremendous overall advantage in its purchasing in that it carries far less selection and buys in volume that's easily 10x that of Amazon. Its COS should reflect much cheaper product acquisition costs. Yet its advantage over Amazon is negligible.

In other words, Amazon is earning comparable gross margins despite subsidizing shipping. As Amazon improves other drivers of its COS (e.g., volume purchases leading to product acquisition cost discounts), I expect it will subsidize shipping even more. And as Amazon builds more fulfillment centers nearer to its customers, its costs of shipping will go down.

One can easily imagine a day when Amazon subsidizes the full cost of shipping, retains product cost advantage over traditional retailers, and provides overnight (or even same day) delivery. All the while maintaining a gross margin sufficient to cover its operating expenses and provide a tidy profit.

Second, the subsidized shipping presents a formidable challenge to other online retail competitors. Amazon is the trend setter. The more they set the standard for low-cost shipping, the more consumers expect it in all online transactions. If the competitor cannot provide it - and the consumer can purchase the same or similar item from Amazon for a cheaper price - the competitor loses the business.

This creates a powerful barrier to entry. Smaller operators that can't match Amazon's scale (and none can) will only be able to subsidize shipping by charging a premium purchase price. And if the buyer can get the same item at Amazon...

(As an aside, online retailers that find ways to compete with Amazon in this regard - Quidsi's diaper.com and Zappos both come to mind - are quickly neutralized. Amazon offers their inventory, undercuts their prices, attempts to replicate their service advantages, or acquires them. See the Business Week story of Quidsi here. The moral of the story: Amazon is deadly serious about preventing other retailers from gaining a toehold in their business...they want complete web retailing ubiquity.)

Conclusion: Definitely offensive. An investment in long-term competitive advantage that hurts competitors, garners greater share of online and traditional retailing markets, and leads to accelerated scale benefits. 

This post is getting too long, so I'll split it up. Next, we'll consider whether lowering prices is an offensive or defensive move.

Walmart (WMT): Part Six - Is Walmart Cheap?

Last time we considered that Walmart market value has gone sideways for at least eight years. If we define owner earnings as the cash available for the benefit of equity owners either directly (e.g., payouts through dividends or share buybacks) or indirectly (e.g., reinvestment into profitable business growth), we can see that management has increased that from about $7 billion in 2003 to about $18 billion in the most recent full fiscal year. That's over 13% compounded annual growth. 

All the while, the stock price has gone from a peak of nearly $64 in 2003 down to about $50 today for a compounded annual SHRINK rate of 3%. So, it's clear that the share price and the value of the company have been at a disconnect. How does that relationship look today?

   

On the basis of owner earnings, at $50 per share the company is …

1. Very cheap on an historical basis. We saw this in the last post where Wal-Mart’s owner earnings multiple has dropped each year from 40x in 2003 to about 10x now, making it the cheapest it has been over the entire eight-year period.

2. Cheap to very cheap on a relative basis. Based on my rough estimates of owner earnings for some other key retailers, Wal-Mart is trading below all of them. Home Depot is currently valued around 15x owner earnings, Costco about 27x, Dollar General is 14x, and Target is 9x.

3. Pretty cheap on an absolute basis. 10x owner earnings implies that Wal-Mart produces a 10% yield for the benefit of owners based on the price they would pay to own its stock today. For my tastes, screaming cheap for a good company about 15% yield (~7x), but for great companies with strong prospects I can stomach as high as 20x owner earnings (5% yield).

All modes of cheap, however, are not created equal. It makes me think of the quip attributed to Woody Allen, "Just because I'm paranoid doesn't mean they're not after me." A business can appear cheap on a variety of measures and, more likely than not, it's cheap because it's legitimately not worth more than its price. There is a special danger inherent to making comparisons when trying to establish the value of a business, whether you're comparing it to itself (historical) or to similar companies (relative). Perhaps it appears cheap because it has exhausted all growth prospects that helped speculators rationalize its 40x valuation eight years ago. Or perhaps it ceded its competitive advantages to other retailers and now must fight in value-diminishing ways to maintain its market share. Reasons abound for cheap value matching cheap price.

That's not to suggest there is no benefit to reviewing historical or relative measures of cheap, but they must be steeped in two additional thought processes to make sure they aren't just leading you into a value trap.

The first is a relatively simple question you can ask yourself and treat it like a point on a safety check-list: Is the business cheap on an ABSOLUTE basis?

The full implications of that question are more complex than the check-list concept might suggest. It's largely a measure of placing the business in a state of suspended animation - taking a snapshot of where it stands today - and evaluating it as if it were an interest bearing investment. Take owner earnings, compare them to the price at which you're buying the business, and equate the percentage to interest paid against your principle investment. If the rate satisfies your return requirements, you can check the box.

For example, with Walmart trading at 10x owner earnings we can say that buying the business for $50 yields you $5 in earnings. If you return requirements are 10% or less, you have satisfied that checklist item.

Hypothetically, you could  stop here if you had good reason to believe Walmart will continue operating in AT LEAST as good a state as it currently exists.  You can say it's cheap on an absolute basis. But investing is rarely that simple. The second thought process can take you deep down the rabbit hole...

What does the future hold for this business?


The essence of investing is divining the future. Even if you're trying to check the simple box of whether a business is cheap on an absolute basis, you're making implicit assumptions that the business will continue generating the same amount of owner earnings into the future. That assumption requires further assumptions about access to and use of capital, competitive landscape, size of the market, etc. in what can seem a forever branching sequence of questions and even more assumptions. I'll avoid any attempt at the discussion here, but it's no stretch - when considering how variable A affects variable B changes variable C, ad infinitum - to say a business is akin to a chaotic system (using the physics definition) in which specific outcomes (the future) are by definition unpredictable and therefore unknowable. You will get it right from time-to-time, and perhaps even more often than not. But unless you have a reliable process for approaching it, you have no basis of saying your success (or lack thereof) is based on anything more than pure chance.

What is a reliable process for attempting to divine the future? One that confesses extreme ignorance of precise outcomes and gears itself instead to avoiding big mistakes. One that looks for advantages and still makes conservative estimates of future performance. One that eschews lazy-minded optimism in favor of a wide margin of safety.

Next, we'll discuss a way to think through margin of safety in valuing Walmart.

Walmart (WMT): Part Five - Sideways Action Deflates the Value Balloon

In its fiscal year 2003, Walmart generated about $7 billion in earnings that went to the benefit of its equity owners. It paid a modest dividend, plowed the rest back into the business, and then borrowed another $3.8 billion to invest even more into its growth.

It was good times for the world’s biggest retailer. The company’s market cap hit $283 billion – more than 40x those $7 billion in owner earnings – revealing investors’ enthusiasm about the business; about their belief that it was going to grow and grow and grow.

And grow it did. Revenue has jumped from $247 billion to nearly $422 billion. It has reinvested over $90 billion to build new stores, strengthen its already formidable distribution and technology edge, and expand internationally. And those owner earnings have compounded at a rate of 13.5% each year since 2003, reaching $18 billion this most recent fiscal year, 2011.

Surely those investors who saw their digital certificates of stock blink up to $63.75 in 2003 have made out like bandits, riding the impressive operating results wrought by Wal-Mart’s management over the decade. Right?

No.

As I write this, Wal-Mart’s market value is about $181 billion. That’s right. Despite years of business expansion, compounded owner earnings, dividends paid, and shares repurchased, the market value of the company is 35% less now than it was then.  Does this make sense?

Well, yes. It pretty much does.

Paying 40x owner earnings for any company is hard to justify. Wal-Mart, the great business that it was (and is), was overpriced.  What tends to happen in these cases is one of two things.

One, something about Wal-Mart’s operating performance, the stock market in general, the world economy, etc. spooks investors and sends them running for the exits, popping the inflated balloon that was Wal-Mart’s stock price.  This is common for hot “growth” stocks where the value depends on optimistic (nay, drug-induced?) assumptions of their continued growth. When circumstances no longer allow speculators to delude themselves, they panic and send the stock price into a nosedive with their selling. Don’t be surprised when you see this happen to…salesforce.com (CRM) selling at 191x its net earnings, Dunkin’ Donuts (DNKN) selling at 179x, or even a powerful force like Amazon.com (AMZN) selling at 83x.

Two, investors avoid an overreaction, but let the air out of the balloon one small deflating puff at a time. There is no panic, but no new buyers emerge for the stock at the high valuation and existing owners – perhaps realizing this, or perhaps recognizing that they bought too high, or perhaps from boredom that the stock price isn’t moving – start a slow sell. Though it lacks the excitement of a pop, the air just gradually seeps out. 

For owners of Wal-Mart at $63.75 in 2003, the process has been slow and excruciating. Things have just gone sideways for over eight years. The high multiple of owner earnings at which investors have been willing to buy the stock in any given year has drifted from 40x to 37…31…23…16x. And today, with a price hovering around $50 per share, Wal-Mart is trading at about 10x its fiscal year 2011 owner earnings of $18 billion (give or take).

So, the question becomes, is Wal-Mart now an attractive opportunity for new investors?

Walmart (WMT): Part Three - Benefits of Parsimony, the Right Premise & Indoctrination

Walmart possesses a culture that rallies around a simple "low cost + low price = more customers + higher volume" theme. The idea, initially a retail experiment by Sam Walton, represents the premise that drives Walmart's entire business. The idea is simple, the execution is tremendously complex. But the simple idea carries with it the benefit of parsimony (or, KISS...keep it simple stupid!), reducing the amount of deliberation required to make those difficult or confusing decisions that pop-up each and every day in business. 

In an environment of complex choices leading to uncertain outcomes, humans often fall victim to either "CYA Syndrome" (cover your ass by making choices you believe will offend others the least rather than those that might lead to greater benefit) or Paralysis by Analysis. The latter tends to manifest itself in one of two forms. 

First, decision-makers err on the side of more information and more analysis in a belief this will help them make the ideal choice. They hold meeting after meeting, soliciting input from an expanding ring of people, crunching more numbers, and generating a long paper trail of memos. The process takes a lot of time and, by virtue of involving more people, creates a "complicity cover" (i.e., the more people you involve in the decision, the more you can spread blame if the outcome is bad). 

Second, would-be decision-makers use analysis to suffocate the very act of making a decision. They hide behind it, biding their time (yet acting very busy) until the issue loses any sense of urgency and just quietly dissolves into the periphery.   

But when the principle of parsimony comes into play, guided by an easy-to-understand premise (or raison d'être), complex matters can be quickly reduced to their lowest common denominator and the potential decisions re-framed in terms of how they help the organization abide by the premise.  Default one becomes "do something simple instead of something difficult." And, for Walmart at least, default two becomes "make the decision that lowers costs, thereby lowering prices, thereby bringing more customers in the doors, thereby increasing volume, thereby increasing returns."

Sam Walton was not the first retailer to champion this philosophy. A recent book by Marc Levinson, The Great A&P and the Struggle for Small Business in America, provides insight into what may have been the earliest implementation of what became the Walmart way. This quote, from the book, is attributed to John A. Hartford, part of the brother duo running A&P.

"We would rather sell 200 pounds of butter at 1 cent profit than 100 pounds of butter at 2 cents profit."

The sentiment is hardly different an example in Walton's tome, Sam Walton: Made in America:

"Here's the simple lesson we learned...say I bought an item for 80 cents. I found that by pricing it at $1.00 I could sell three times more of it than by pricing it at $1.20. I might make only half the profit per item, but because I was selling three times as many,  the overall profit was much greater...In retailer language, you can lower your markup but earn more because of increased volume."

He wasn't the first to understand the power of low prices and high volume. In fact, it didn't take genius level retail IQ to latch onto that insight and turn it into the basic premise of the entire Walmart operation. Good ideas...even some of the best ideas...are worth nothing unless the person or the organization has the ability to execute on them. And this particular premise has been difficult to execute in a live-fire business setting. Why?

My first suggestion is that it's not such a simple task to get a group of people lined up behind a common purpose. But Walton was unrelenting. He screened new employees based on how well they seemed to buy into the Walmart premise. One can imagine he was ruthless in pruning out executives who attempted to stray from the idea. He became cheerleader extraordinaire for the cause, championing the Walmart premise throughout the organization. He instituted a company cheer, still in place today, that culminates with associates responding to "Who's number one?" with "The customer! Always!" Walton was, ultimately, a master at indoctrination.

Consider the following account by an early Walmart manager (from Charles Fishman's bestseller The Wal-Mart Effect):

"We would sit around a big table, and Sam would talk to us like a Dutch uncle. He would say, 'You see this pen? We're selling it for 88 cents. It's a good pen. We're paying 60 cents for it. We could write an order for this at 60 cents and sell it at 97 cents. But we don't. We want to sell a good product at the best price. And make sure we've always got it.'"

My second suggestion is that the temptation is always high for retailers to stray from low-cost + low-price.   When it was founded in 1962, Walmart was not the only company attempting to get into the discount store game. Indeed, Walmart, Target, and K-Mart all came out that same year trying to make similar jumps from their variety formats into discounting. Each was dedicated to growing through volume, using the power of bigger stores in more markets to extract better pricing from suppliers.

Writing an early post-mortem on the competition, Walton penned the following words in the early-90s. From his book:

"What happened was that they didn't really commit to discounting. They held on to their old variety store concepts too long. They were so accustomed to getting their 45 percent markup, they never let go. It was hard for them to take a blouse they'd been selling for $8.00, and sell it for $5.00, and only make 30 percent. With our low costs, our low expense structures, and our low prices, we were ending an era in the heartland. We shut the door on variety store thinking."

Bumping up margins by bumping up prices has always been a siren's song for retailers. It's easier to let prices creep up a penny here or a penny there, feeding higher gross margins, providing a comfortable cushion to pay for your overhead expenses. It's easier than cutting expenses, firing people, reducing salaries, forgoing the nice headquarters building, etc. Surely the customer won't notice just a little increase in prices, right?

Walton understood the slippery slope of that thinking, and so he worked tirelessly to imbue his Walmart culture with a sense of repugnance for higher costs and higher prices. Again, from the Fishman book:

"'Sam valued every penny,' says Ron Loveless, another of Sam's early, legendary store managers...'People say Wal-Mart is making $10 billion a year, or whatever. But that's not how the people inside the company think of it. If you spent a dollar, the question was, How many dollars of merchandise do you have to sell to make that $1? For us, it was $35. So, if you're going to do something that's going to cost Wal-Mart $1 million, you have to sell $35 million in merchandise to make that million.'"

We'll allow that idea to close this line of thought. I've meant to convey a rather simple point, but that gets tangled easily in all this writing. Perhaps it boils down to this: 1. Parsimony is better than complexity when it comes to helping people sort through their myriad daily decisions; 2. The right premise - steeped, of course, in parsimony - helps ease the decision making process while avoiding problems like paralysis by analysis; and 3. If you have the right premise, you will benefit from indoctrinating your people and making sure it becomes an enduring part of your culture.

This, I believe, defines the successful low-cost, low-price culture of Walmart. And if we're studying Walmart only to marvel at its culture, we can stop our analysis there. We are, however, evaluating the company as an investment opportunity and must segue into our next series of questions, starting with...Has its strength become its weakness?

Now, looking to the future...If the company can only build so many more supercenters before saturating its markets and cannibalizing its sales...if the company is battling reduced buying from penny-pinched customers...if same store sales are stuck...in what kind of predicament does Walmart find itself if it wants to continue to grow revenue but refuses to raise prices?

Has the simple premise that has worked so remarkably for 50 years become more of an anchor, slowing the momentum of the Walmart ship, than an engine driving it?

Walmart (WMT): Part Two - Raison D'être

Our Reason for Existing

After three hours of high-energy corporate pep rally, Walmart's CEO - Mike Duke - strides onto stage to bat clean up. The setting is the company's annual shareholders' meeting, emceed by Will Smith and featuring a cavalcade of senior executive speeches and heart-warming vignettes on the dedication of Walmart associates.

Whether from Doug McMillon of Walmart International, Brian Cornell of Sam's Club, or Eduardo Castro-Wright of walmart.com, each manager preceding the CEO has used his stage time to extol the virtues of what they call the Productivity Loop: Operate for less through every day low costs (EDLC), which leads to...Buy for less from suppliers, which leads to...Sell for less to customers with every day low price (EDLP), which leads to...GROWTH! And the loop circles around the unifying theme of "Saving people money so they can live better."

It's a steady drumbeat, and it's loud. Audience members will not leave this meeting foggy on the takeaway points. Yet it's not limited to one meeting. Review any public presentation by a Walmart executive (you can find them here) and you will see that each returns to these same ideas over and over and over again.

Back at the shareholders' meeting, Mike Duke comes on stage, keeping the streak alive with yet another speech about the Productivity Loop. As he highlights the connection between EDLP and EDLC, he walks to  the podium and grabs a well-worn copy of Sam Walton: Made in America, opening it as if he's preparing to read chapter and verse from scripture itself.

Duke says (and I'll paraphrase to a degree),

"I picked this book off my shelf and read it again this week, for what must be the third or fourth time. And let me share with you what Mr. Sam has to say about EDLC...'We exist to provide value to our customers, which means that, in addition to quality and service, we have to save them money. Every time Walmart spends one dollar foolishly, it comes right out of our customers' pockets. Every time we save them a dollar, that puts us one more step ahead of the competition - which is where we will always plan to be.'"

Duke closes the book and holds it up solemnly for the auditorium to behold. They clap reverently at Mr. Sam's immortalized words just before the current CEO sums it up with this statement:

"No one controls costs better than Walmart because we do it for the right reason. It's for our customer."

There. That's Walmart's raison d'être. It's reason for existence.

The final genius of Sam Walton may have been just that...distilling a retail philosophy into just a few pithy statements, making it so much easier to build and maintain a company culture on these simple, unifying themes. So much so that his company executives continue to refer to him as Mr. Sam nearly twenty years after his death and keep dog-eared copies of his book lying around just in case they need a fresh injection of his wisdom. So much so that a company with 2.1 million employees, over 9,000 retail outlets, operating in 28 countries, and with sales approaching the half-a-TRILLION mark...continues to stick to the same simple, unifying themes.

Next...the "principle of parsimony" when combined with an accurate raison d'être makes for formidable force in retailing.

Walmart (WMT): Part One - Simple, Unifying Themes

There is something to be said for the simple rallying cry, the unifying principle, the lowest common denominator upon which to rely when in doubt. The human mind, as we're told by cognitive psychologists, is not so good at juggling multiple ideas at the same time. It's quite bad at managing priorities when given unclear directions. And it's just plain terrible - paralyzed even - when asked to act on what it perceives to be conflicting ideas or directions.

F. Scott Fitzgerald noted the following in this 1936 article for Esquire magazine: 

"...the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function."

Though most of us consider ourselves first-rate lovers (especially the French), drivers (especially the Swedes), and investors (this bit of overconfidence is equal opportunity), in reality these skills - as well as possessing a first-rate intelligence - tend to distribute along a bell curve, meaning most of us (irrespective of our confidence) are going to be just plain average at each. So when we create systems in which our fellow humans must make decisions, we are increasing the odds of them making the correct decisions if we reduce their options, provide them clear priorities, or at a bare minimum provide them with a simple rule to use when in doubt.

Through much of my life I've had a fascination with politics, enjoying in particular - almost as a connoisseur - the finer elements of a well-run campaign. One of the best in terms of providing simple, unifying themes was the 1992 candidacy of Bill Clinton. The behind the scenes drama is captured in a spectacular documentary, The War Room. 

Now imagine a national campaign. You have so many constituencies that have conflicting and overlapping agendas - voters, interest groups, supporters, opponents, media, Congress, etc. A campaign can easily derail itself trying to patchwork a message to satisfy each. Those with the most success, however, jettison the complex and nuanced messages in favor of simple, overarching themes. For that 1992 campaign, political operative James Carville reduced all the complexity to three simple rules, displaying them prominently for all to see everyday: 1. Change vs. More of the Same; 2. The Economy, Stupid; and 3. Don't Forget Healthcare.

These three things, they believed, captured the fears and hopes of the electorate, highlighting the strengths of a challenger versus an incumbent, and kept the conversation away from Clinton's recurring personal foibles.  

It worked for two reasons: One, they picked the right themes. Voters were worried about the recession, and despite George H. W. Bush having historic approval levels coming out of a quick and decisive victory in Gulf War I, people were concerned about their jobs and quick to ask "what have you done for me lately?" The Clinton campaign was able to paint a picture of the incumbent as ineffective on economic issues.

This is a critical point. Not any theme will do. You can't just pick one, beat the drum often and loudly, and expect it will work every time. The message must have resonance. It must be the right message. If Carville and crew had selected the wrong one - if it rang hollow to campaign staff and/or voters - the in-the-trenches workers would have dropped it. (Note: Line workers can be brilliant at subversion when you haven't won their buy-in.) 

Second, communications staffers and the candidate pounded the messages home with unrelenting discipline. When media questioned them about any topic, their job was to always bring the conversation back to these three points. They were able to do it because the themes were simple, easy to remember, and (importantly) the staff allowed itself to be indoctrinated, truly believing that these were the right messages to share.  

Campaigns and businesses are worlds apart in many ways, but in this regard I believe them to be quite similar. They are both complex organizations attempting to influence diverse constituencies to achieve some goal. For companies, they need customers to recognize the benefits they offer. They need investors to buy-in to their model. And perhaps most importantly, they need to influence employees - who operate in that dense fog of commercial war - to make good decisions that reflect well on the firm and support its objectives.

Granted, nearly all companies recognize the power of unifying themes. They hire skilled executives for the sole purpose of internal communications, they create catch-phrases and missions statements, and they work hard at staying on message. But more often than not, their themes fall short of defining the business, unifying its constituents, and providing direction. They lack authenticity. They lack resonance. For employees at all levels, they lack the unifying and defining ability to provide...PURPOSE.

What businesses actually do this well? 

I believe Walmart is among the best. The direction was provided by Sam Walton, entombed in his autobiography (Sam Walton, Made in America), and imprinted constantly on his managers and employees. Provide customers with the goods they want at the best prices possible, and they will buy from you before they buy from the competitors. Everything stems from this premise.

In the next few posts we will examine the Walmart credos, accepting as a given that the message is simple and well-delivered, and thinking about whether it remains 1. an accurate premise; 2. in support of a viable business model; and 3. that it helps justify an investment in the business at current prices.