Secret Ingredients

BAM! With that one-word, signature exclamation, celebrity chef Emeril Lagasse is trying to tell you something. He wants you to pay attention, because he's about to add something special to the pot, an ingredient or spice that you probably hadn't thought of. This, you see, isn't your grandmother's gumbo recipe. It's Emeril's, and it calls for 12 ounces of amber beer. Grandma, by contrast, always liked to cook with sherry--and sometimes she even put some in the food. BAM!

There are not supposed to be any true secrets in the stock market, given the laws about disclosure and against insider trading. However, there are times when information may be widely known and yet still not fully understood or appreciated.  The theory tells us that all information is known and immediately reflected in stock prices, thus making the market efficient. This makes it difficult for investors to gain much of an edge, supposedly. But what about situations where a big change occurs, such as when one company buys another company, and it takes some time for the analysts who follow the stock to grasp fully the implications for the combined entity's future? This may be less of a secret ingredient and more of a special spice, the added element that provides that extra kick, something for your portfolio, rather than your taste buds, to savor.

Even novice investors understand that nice profits can accrue from owning stock in a company that is the object of an acquisition. Typically the stock of the company being bought will soar, while the stock of the company doing the acquiring may slip a bit, presumably because they are going to be shelling out a lot of money. But sometimes the company doing the acquiring is the one reaping the most benefits. Shares of Valeant Pharmaceuticals (VRX, $202) soared some 25 points (15%) Monday on the news that it had struck a deal to acquire Salix Pharmaceuticals (SLXP, $156) for $158 per share. VRX is something of a serial acquirer, with the notable acquisition of Bausch and Lomb from private equity firm Warburg Pincus PLC in 2013. VRX has stated that its goal is to become one of the top pharmaceutical companies in the world, and it plans to get there by buying other companies. Pushed by activist investor Bill Ackman, Valeant tried to buy Botox-maker Allergan (AGN, $232) last year, but lost in the bidding to Actavis (ACT, $289). Actavis today is itself the result of a combination with what was once Watson Pharmaceuticals, then known primarily for its generic drugs. What the Salix and Allergan deals have in common is that these are both specialty pharmaceutical companies with strong franchises, Salix with its gastrointestinal treatments and Allergan with Botox. Wall Street seems to like all of this, even if tracing a corporate lineage can be more complicated than figuring out the family relationships in a William Faulkner novel. Shares of Salix are up 237% over the last three years, and shares of Allergan are up 164% over that time span. But that same three years saw Valeant rise by 314% and Actavis by 400%.

As we noted in the last post here, companies can start down the acquisition trail in an attempt to reverse declining relevance. One of the more obvious areas of the economy threatened by irrelevance is the newspaper business, as people get more of their news through non-print sources. Gannett (GCI, $35), best known as the publisher of USA Today but also the owner of many other daily  and weekly papers, has responded to declining ad revenue from its printed media by going on a shopping spree for television broadcast stations. General Mills (GIS, $53), known for cereals such as Cheerios, Trix, and Lucky Charms, has sought a greater presence in the healthier food category by acquiring Annie's, a maker of natural and organic foods. Tyson (TSN, $41), the major purveyor of chicken, has bought Hillshire Brands, thereby adding pork and a variety of packaged foods to its corporate menu. The Tyson situation intrigues me, because the stock is up only about 5% over the past year. Investors were spooked by the high price that Tyson had to pay for Hillshire to prevail in a bidding war against chicken rival Pilgrim's Pride (PPC, $27). We'll be watching to see whether Tyson can realize the projected cost synergies from this combination.

As for the cost savings that can result from a corporate marriage, they are not unlike what occurs in a literal marriage. When two people get married, assuming they have not already been living under the same roof, they enjoy the magic economics of reducing the expenses of two households to the cost of supporting only one. Just another of the many benefits of marital bliss. Critics will contend, though, that "cost synergy" is really a euphemism for "job loss." That can be true, but it is not necessarily the case. Valeant, for example, has said that it has no plans for any reductions in Salix's specialty sales forces, given their specialized knowledge of the company's gastrointestinal treatments. And we can only speculate as to whether the cameras would have rolled for a new Star Wars movie (to be released later this year) had Disney (DIS, $105) not bought Lucasfilm. For that matter, Captain America might be languishing in comic book limbo today had Disney not brought Marvel into the corporate fold.

That really brings us back to our main point, which is that the ultimate benefits of such corporate combinations may not be initially obvious. This is true of any major change, of course, and the outcome can be very positive or it can be a miserable failure. Such changes have a way of throwing existing assumptions and projections off of a comfortable equilibrium, and uncertainty can prevail for a time. The analysts will even tell us that their earnings models for a particular company do not include the impact of an upcoming acquisition. What we can say is that Disney is a very different company today from what is was 20 years ago, before ESPN, ABC, Pixar Animation, Marvel, and Lucasfilm. Big acquisitions are not always transformative game-changers, and that calls for careful analysis to distinguish the opportunities from the traps, to find those situations where one-plus-one might equal more than two. If we follow Emeril's command to pay attention, though, we might just get to enjoy some tasty new gumbo.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of VRX, ACT, GCI, TSN, and DIS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

Copyright MMXV

The Relevance Quotient

One of my favorite modern quotes comes from General Eric Shinseki, the retired U.S. Army Chief of Staff, who said, "If you don't like change, you're going to like irrelevance even less." Memorable and enduring thoughts, nailed down with succinct quotes, can take on a meaning much larger than the specific context in which they were originally expressed, and that is certainly true here. Whatever the General meant originally, his idea can lead us to see failure as a particular consequence of irrelevance, and to examine change as an antidote for--or, better yet, an inoculation against--such irrelevance.

For our purposes here, we'll note that an enterprise can be a bad investment long before it becomes an outright failure. I have been picking on Radio Shack in this space for the last several years, although the true object of my scorn and derision has been the group of analysts who insisted that the stock was "cheap" and a "value" as the share price declined from $15 to $12 to $8, and so on down. The point is that we don't need to pass the Chartered Financial Analyst (CFA) exam to see what's going on in the world around us. I am tempted to think that such financial expertise could actually be a hindrance if it comes at the expense of our God-given common sense. Relevance is big picture stuff, and by the time evidence of it is manifest on an income statement, it's probably late in the game. And it is not a matter of a company's goods or services being relevant or irrelevant (that would be binary thinking), but rather a question of whether those goods and services are declining or increasing in relevance.

Investors are prone to suffer from a form of denial that usually begins with the statement that People will always buy.... Fill in the blank: Kodak film, because they will always take pictures? McDonald's hamburgers, because they will always want fast food? Sears, because they sell everything? The problem with such rationalization is that it fails to appreciate the brutality of change at the margin. No, everyone does not have to quit eating Quarter Pounders to send McDonald's (MCD, $95) into declining relevance territory. The company just has to lose customers at the margin. I have heard more than one investment analyst suggest that what McDonald's really needs to do is streamline its menu, that the offerings are overloaded and complicated. But don't you actually have to go to McDonald's to know what's on their menu? The parents who are feeding their kids at Whole Foods Market (WFM, $56) are not going to go to McDonald's even if the company started giving away granola with the fries. Even if the health--conscious do indulge in the occasional Happy Meal for the kids, they are not going to do that on a regular basis. And that's really all it takes to cause trouble.

If the relevance of McDonald's is threatened by the trends in healthier eating habits, the company's other raison d'etre, quickness and convenience, is under siege from the likes of Panera Bread (PNRA, $154) and other fast casual chains (the Panera in Midtown Memphis has a drive-thru!). Sometimes you just want a good old burger, I know, but that could soon be a smartphone tap away once food delivery apps from GrubHub and Yelp's Eat24 roll out across the country. If I have that option, my burger is going to come from Huey's (the best burger in Memphis). As for the changes that could have salvaged the company's relevance, I'll just point out that MCD was once a major investor in a start-up known as Chipotle Mexican Grill (CMG, $672) before divesting itself of that enterprise in 2006. The shares of CMG are up more than 500% over the past five years alone. I'm not Lovin' It, McDonalds.

For an example of where imaginations were not calcified in the corporate executive suite, we have Netflix (NFLX, $467) and its chairman, Reed Hastings, who saw early on the declining relevance of the mail-order dvd rental business. The company reinvented itself as a provider of streaming video and, later, as a producer of original content (my wife and I will binge watch House of Cards when the new season is released later this month). CVS (CVS, $102) saw an opportunity some years ago when it bought Caremark for its own Pharmacy Benefits Management (PBM) division, then more recently ditched cigarettes and renamed itself CVS Health. Coca Cola (KO, $41) bought a 16.7% stake in Monster Beverage (MNST, $119), the energy drink company, and also a stake in Keurig Green Mountain (GMCR, $118), both in 2014. Coke acquired the Odwalla brand of fruit juices in 2001. All of these changes can be viewed as attempts by these companies to get on the upside of relevance.

And then there are those companies that don't have to change themselves--yet--because they are in the sweet spot of relevance already. Palo Alto Networks (PANW, $137) is benefiting from the rising tide of concerns about cyber security. Cerner (CERN, $70) provides health care information technology solutions and has seen its business thrive with the shift to Electronic Health Records (EHR) systems. Hain Celestial (HAIN, $59) and White Wave Foods (WWAV, $39) are in the organic foods space and are riding the wave of healthier eating habits. Zoe's Kitchen (ZOES, $31) is a relatively new (as a public company) and unknown entrant in the healthier fast casual restaurant space.

Let's not make this any more complicated than it has to be. If we ask ourselves the question, What problem is this company solving? and we find that either the answer is evading us or that someone else is solving the problem, we might be on the trail of declining relevance. We could also just follow Amazon (AMZN, $373) the way we might track a kettle of vultures to find their latest prey. As soon as we realized that AMZN was going to be selling a lot more than books, we should have started sniffing for the walking dead retailers--and there we would have found Radio Shack and its handy but increasingly irrelevant storefronts. At the same time, let's not oversimplify the investment dimension here. Just because a company's goods and services are gaining relevance traction does not automatically make their shares a good investment. There's always much more due diligence to perform.

When I was a kid in the 1960s, my friends and I eagerly awaited the arrival of the Sears Christmas Wish Book in the fall. It was chock full of the latest toys that we could write to Santa about. I especially remember one of my favorites, the robot from the television series Lost in Space. It was under the tree on Christmas morning, and my father would have his Kodak Brownie camera ready with plenty of extra rolls of Kodak film to snap lots of pictures. He always did that. And he always would, wouldn't he?

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of AMZN, PANW, HAIN, CERN, CVS, ZOES, MNST, KO, CMG, NFLX, WWAV, and WFM. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

The Oldest Profession

Whenever I hear people talking about the newness and novelty of car services like Uber and Lyft, I am struck by the thought that those services are really just the latest expression of a business model that is as old as commerce itself. (No, not that other oldest profession, but a mischievous mind could find parallels there, as well.) The idea of using one's automobile to make some extra cash is no different, in economic terms, from renting out that room in your house that no one is occupying. It is all about putting an underutilized asset to work. It is this notion of underutilization, paired with an enabling technology, that is really at the heart of the economics here.


I will draw one conclusion from observing my friends' and my own use of the services, but this is purely anecdotal, not statistical. On those occasions when I have known my friends to be using Uber or Lyft, I have wondered what these friends would have done for transportation had those services not existed. Would they have called a taxicab? In most cases, no. They would have driven themselves. So, to the extent that this pattern of usage is true beyond my own experiences and observations, I would conclude that the existence of Uber and Lyft is actually enlarging the market for "someone else doing the driving." Sure, they are undoubtedly taking some market share away from taxis and more traditional car and limo services, but from what I see, Uber and Lyft have created a new market of clients who can whip out their smartphones (which they are always engaged with anyway) and summon a ride. This means that people who would otherwise have driven themselves are riding in the back seat--and not behind the wheel. There is a public safety benefit here that the vociferous opponents of the services, the folks who want them banned, should have to deal with in their efforts to keep Uber and Lyft out of the market.

As for the economics, the car services are part of what is being called the new "on demand" economy. Looking at the old economics, though, I would call it a variant of market-clearing pricing. An unbooked hotel room, for example, represents an opportunity cost to the hotel's proprietor, lost revenue that cannot be recaptured. As the date of the vacancy approaches, the hotelier has more and more incentive to book the room at whatever price will draw in a guest--the market-clearing price to get the room booked. The free flow of information is essential to the smooth functioning of a free market, and that's where the Internet comes in, putting that room "on the market" for prospective travelers who might be willing to pack a suitcase at the last minute in order to snap up a bargain. Or consider the off-price retailer T.J. Maxx (TJX, $68), which sells in-fashion clothing at discount prices. The selections here are items that didn't sell at full price elsewhere, and TJX has trained its followers, the "Maxinistas," to check the stores frequently, because the inventory is always changing. And then there is the most familiar example of all, eBay (EBAY, $54), which has given new life to the idea that "one person's junk is another person's treasure." Want to get rid of the stuff in your attic without going to the trouble of having a garage sale? Well, just snap a photo and post the items onto eBay. These are all just variations on the simple idea of trade, with the Internet and smartphone apps taking the place of the want ads.

On a recent outing with Uber, my app informed me that I would be charged 4.2 times the standard rate due to a spike in demand for cars. I had to agree to that, which I did, because it was still a bargain. The driver explained to me that Uber jacks up the prices when demand jumps as an enticement for more Uber drivers to hit the streets and pick up passengers. That, of course, is exactly how supply and demand are supposed to work. If that sounds novel, it would only be because so much of the economy does not allow for the price mechanism to work its magic by responding immediately to changes in supply and demand. The technology makes this possible. This same driver told me also that one night over the Christmas holidays he had made $1,000 in fees and tips, and that he regularly made about $1,000 a week driving for the service full time.

On another night, this one with Lyft, the app wasn't functioning properly. It was telling me that the driver was still seven minutes away even as he pulled into my driveway. The app never acknowledged that he had picked us up, so it couldn't process the transaction for payment when we were dropped off at our destination. I asked the driver if there might be someone at Lyft he could call about the problem. Well, guess what? There isn't, so I settled with him in cash. I love the ease of pressing a button on my phone to summon a ride. It means I don't have to be on hold with a taxi dispatcher, but that is exactly the person I miss when the technology fails. When advances in technology are applied in innovative ways, the result is "creative destruction." Amazon (AMZN,  $370) brings us the ultimate virtual store of anything and everything, but the price we pay is that one day I'll find myself explaining to my grandchildren what a bookstore was. So, we can probably add taxi dispatcher to the list of jobs laid to waste by the bulldozer of progress.

Since I am a great champion of free and unfettered markets, I have to come down on the side of letting the car services compete for business in the marketplace. Of course, another component of a free market is that everyone is supposed to play by the same rules, and it is here that the legacy taxi companies have a point. The answer, though, is not to ban Uber and Lyft, but to instead work out something else. I also have had great experiences with our drivers, not one of whom has reminded me of the latest serial killer from Criminal Minds. The mutual rating arrangement between driver and passenger probably puts more pressure on the driver than on the passenger, and it seems to work. A drunk, unruly, and rude passenger can likely find another source of transportation in the future, easier than a driver can find another job.

One night late when my wife and I were picked up by Lyft to go home, the young lady in the driver's seat looked at me in her rear view mirror and asked, "Do you remember me, Mr. Taylor?" I have never been particularly fond of that question, but she went on to explain that she had attended school with one of our daughters. And yes, I did remember her. She is working full time as an attorney and driving for Lyft to pick up some extra cash. And I suppose it is reassuring to know that if times get tough, I can always pimp out my car.

Life is short. Get busy.

Jim

Disclosure/Disclaimer: My family members and/or I own shares of TJX, EBAY, and AMZN. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.