Two Guys Walk Into a Bar

Two companies walk into an earnings call. The first reports 30% sales growth. Its profitable. Operating profit grew 27%. It paid shareholders a dividend.

Is this good?

The second shop reports that sales were off 40%. It lost money. A lot more money this quarter than the same time last year. Dividend? Lol, no.

Was this bad?

Yeah, for a company making more money is better than losing more money. For investors, whether one is good or bad comes down to how those results line up with expectations.

No Expectations

The price of an investment, in this case, the share price, comes laden with expectations. If investors had expected the first company to grow 10%, they'd be pretty happy with 30%. If they had expected 50% growth, 30% disappoints.

So, Did the first company meet expectations?

It did. Its results were… about what investors expected, a kind of boring outcome.

What about the other company?

Well, that's a bit more involved. The short answer is that shares rose, a bit, after the company reported. So by that standard, the company beat expectations.

The majority of the value of that company, though, 75%, comes from shares it owns in the first company.

Huh?

The vast difference in results is a bit of accounting smoke and mirrors.

Both companies are real estate adventures. The latter bungled the Great Financial Crisis and cast around for a decade looking for redemption. It hit paydirt on ground leases - it owns land and leases it tenants like hotels who pay for everything from the ground up etc. No upkeep costs, no, utilities costs, no investment expenses. You might see why investors like this. Just rent.

The company had a few properties that aren't ground leases that were in various stages of development. While it was considering how to dispose of these, it agreed to merge with another ground lease company and as part of that decided to carve off its other holdings and a handful of its new shares and spin them off to existing shareholders.

My grandma used this same maneuver when she gave her dog his medicine in a spoonful of ice cream. Bert got the ice cream, but he had to take the medicine too. Shareholders got shares in the new ground lease company, but had to take the wind-down portfolio too.

Bert's medicine would sometimes end up on the floor despite the ice cream. Shareholders hate medicine even more than dogs do. They could sell as soon as they received the shares of Leftovers Inc. And they did. They shed shares at prices lower than just the value of the shares held in the ground-lease company. And nothing for the other parts of the portfolio. They gave away the same shares they were so eager to get in the other company for a steep discount.

When LCM looks at whether expectations were met or not, an important question is whose expectations? For investors playing the earnings game, their expectations were met. For the investors who were force-fed the leftovers, their only real expectation was to get rid of the stuff that wasn't ground leases as quickly as they could. They sold and met their own expectations. Meeting those expectations, though, came at a cost - selling the shares well below the value they represent. They didn’t have any expectations for what the company might earn if it got value for those assets because they expected to sell the shares as quickly as possible.

For investors who can take a longer view, like LCM, shares look like an chance to grab an inexpensive low-risk opportunity.