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.

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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...

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.

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.