Advertising mogul Ed Eskandarian is selling his minority stake in the Boston Red Sox to Seth Klarman, a well known Boston hedge fund manager, according to two people briefed on the transaction.

via Boston Red Sox – Minority owner selling stake in Red Sox – The Boston Globe.
 

Seth Klarman, the man who wrote the most famous (or infamous) value investing book of the last ten years, Margin of Saftey (read my review), seems to have made a distinctly non-value purchase. While the details of the transaction haven’t been released, we do know that public consensus on the Red Sox’ value is probably in the $1 billion range or at least 40% above the price paid for the franchise in 2002 by John Henry and Co. 

The Red Sox seem to be reaching a crescendo in their illustrious history with regular rookie of the year contenders, an MVP, two world series in the last 5 years, and a farm system seemingly bursting at the seams. How could Mr. Risk-Averse Klarman see value in this?! 

Just goes to show you, for some things, no risk outweighs the reward.

For more coverage on Apple (AAPL) at The Curious Investor check out the following articles: 

• Looking past accounting tomfoolery – GAAP versus Cash accounting and how you can profit.
• The Value of Steve Jobs per Share – A no-growth valuation of Apple in a supposedly bleak post-Steve Jobs world. It’s not as scary as you might think. 
• The Men who would Replace Steve Jobs – A summary of various sources’ opinions on potential Steve Jobs successors, all of whom happen to already be employed by Apple.
• Lower prices/margins = Better investment? - A look at Apple’s announced plan to lower margins in order to capture market share.
• Apple, Tech firm or not? – A look at why I consider Apple as much a retail play as it is a tech investment. 

As a shareholder, always remember that you have a right to your portion of the Company’s profits. But, as it wouldn’t make sense from a planning perspective to distribute profits each quarter based on the whims of a disparate shareholder group, management and the board of directors is given the fiduciary duty to determine what to distribute and what to keep as retained earnings. As a non-control investor, you must decide whether or not these decisions can create value for you as a shareholder.

Using the example of a savings account, if you chose to put $100 in a savings account, you’d likely demand a return of 3% or more. In the same sense, if management of a Company you’re invested in came to you with the proposition, “We can give you every dollar the Company earns this year or you can let us reinvest the profits and build a bigger more valuable company next year,” you’d have some demands as far as how much more value they can deliver to you. Not to mention the fact that by allowing them to control the Company’s earnings, you’re also giving up the opportunity of taking the money and putting it into a risk free savings account. So, how can you tell if management is effectively reinvesting your dollars or how much to expect from their efforts going forward??

Return on Equity
The simplest measure of investment efficacy is:

net income / shareholders’ equity

Basically, for the capital that shareholders invest in this business, how much profit is returned? As retained earnings are held on the balance sheet within shareholders’ equity, this simple ratio gives you proxy for how well the Company has generated return on equity investments so far and the incremental net income growth you should expect on each dollar of earnings you allow them to retain.

Return on Invested Capital
ROE is inherently weakened by the fact that businesses can secure investment capital in more ways than just equity. If the Company borrows a lot of money to fund growth, it can juice its return on equity numbers pretty significantly. A better metric might look like:

net income / (shareholders’ equity + longterm debt)

This number, for any business that has long term debt will be lower than, return on equity. But, it is likely a more accurate picture of the return you can expect for each marginal dollar that management spends to grow the business.

Is higher ROE or ROIC always better?
Remember that ROE and ROIC are inherently backward looking formulas. They can only be used  for you to evaluate how management has invested capital historically. The law of diminishing marginal returns implies that return on each new dollar invested will fall in the future.

The best management teams do one of two things.

1. They maintain or grow on their historical ROIC rates.
2. Or, they recognize the diminishing value of their efforts and move quickly to distribute profits to shareholders as opposed to waste it in ill conceived attempts to grow the business.

Large acquisitions, the start up of new non-core businesses, ever increasing headcounts, and continual purchase of new equipment are all examples of red flags. Remember that sometimes you won’t see net income growth immediately but, if return on invested capital remains at depressed levels or continues to decline over a several year period, it may be time to get out of Dodge.

Just to summarize the aforementioned article, promotional mark downs are typically used in an attempt to entice a higher volume of purchases to juice declining revenues and clear inventory. The main pitfalls to such a strategy include:

1. Increased volume at lower margins not translating into higher revenues. Few buyers will buy a poor product even at a discounted price.
2. Reliance on discounting is often a result of structural weakness in a Company’s merchandising decisions. 
3. Repeated use of voluntary discounts run the risk of turning into a permanent loss of pricing power through what I call “the sale spiral.” Customers become accustomed to bargain basement prices and lower their reservation price for the Company’s products altogether.

In my previous article, I assumed discounting was the direct result of difficulty enticing customers to buy product. But, what about discounting in the face of a recession and overall tightening of wallets? If the industry as a whole begins discounting, do the same principles of loss of pricing power, profitability, and brand image apply? One company, Abercrombie and Fitch, believes so and has chosen to stay away from running promotions in addition to their annual clearance in hopes of maintaining its brand image and, more importantly, pricing power.

Throughout the last two years, Abercrombie has maintained gross margins at its historical (and astronomically high) levels of 66+% despite a significant consumer downturn. As expected, the company’s same store sales have collapsed and net income last quarter was down year over year for the first time in the last ten years. 

Abercrombie is making a calculated bet in maintaining prices despite the fact that competitors have been slashing prices across the board. My assumption is that it hopes that by bucking the trend it can accomplish the following:

1. Maintain its “casual luxury” image by not chasing its demographic down market. 
2. Magnify its brand appeal through its relatively “aspirational” pricing. The company hopes that empty handed teenagers will be walking out of the store thinking, “Someday when I have the money, I’ll buy tons of Abercrombie!”
3. Capitalize on consumer surprise when competitor prices jump back up to pre-recession levels and Abercrombie’s “miraculously” stay flat. 

 The problem, however, is that for this strategy to work Abercrombie must prove to have a truly defensible luxury product. My contention would be that teen apparel is very subsitutable. It is, after all, difficult to establish “aspirational” status for ripped jeans and double entrendre t-shirts.  In trading down or going to other similarly “aspirational” teen retailers like Urban Outfitters which are running sales, customers may find that that they don’t necessarily need to return to Abercrombie. 

In addition to long term risk to the Company’s demographic appeal, the decision to maintain prices in the face of lower revenues has put some stress on the Abercombie’s balance sheet that will have to be dealt with.  A quick look at Abercrombie’s inventory and cost of goods sold finds that the Company held $505 million in inventory at the end of last quarter, up from a typical $400 million-ish that are typically held through the last two quarters of the year. Assuming COGS as a proxy for inventory moved in a quarter, we find that Abercrombie typically purchases ~$300 million in inventory per quarter which would imply that the Company held almost two quarters’ worth of inventory at last check. In all likeliness, this backlog is mostly fall and winter clothing. Sooner or later the Company will have to clear this inventory, probably before summer. Knowing how quickly fashions can change, I wouldn’t imagine that it will be easy to move this build up without eventually succumbing to the so-called “promotional pied piper. “ 

Full disclosure: No positions held in any of the Companies mentioned in this article. 

As far as any posting plans for today, I just wanted to draw people’s attention to this very good article entitled, The True Cost of Bailouts. It’s a quick FAQ/Primer on how the government is funding its various “bailouts” and what it will mean to our economy in the future. I won’t get on my soapbox again, but I think frequent readers of this site will know that I generally believe that recent government intervention has been necessary and will ultimately prove beneficial to all of us in the longrun.