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Drama. It’s endemic to many investors that “stock prices” satisfy a “power law” similar to the one that is familiar to physicists: P = V×I, where P is the “power” that is generated by a circuit at “voltage” V and “current” I. In the case of investors, the equation is:

[SF] = [P/E] × E

where E=EPS, is the “earnings per share” and P/E is the price-to-earnings multiple if the equation is exact, but more usually it is the [P/E] which is representative of that type of company so that the “stock price” [SF] is “fictional” and a benchmark for that type of company.

We could say, then, that stock prices above [SF] are powerful and stock prices below [SF] are powerless.

Courtesy: Lumber Liquidators

In the case of Lumber Liquidators, the current deemed [P/E]=60.5× and the current EPS=\$1.80 per share suggest a “fictional” stock price of [SF]=\$108.90 and, indeed, the stock has tended to trade between \$100 and \$110 since the beginning of September until today when it closed at \$115 and traded between \$114 and \$118 during the day, and before September when it tended to trade between \$50 and \$90 for most of the year and the stock price is, indeed, up +100% since December. Please see Exhibit 1 below.

Not to be discouraged, however. The equation has a fine pedigree in physics in which the terms “power”, “voltage”, “current”, “work” and “energy” are all closely intertwined and the equation expresses and is a result of the measurable and observable balance of these terms. That is also true in this case when we recognize EPS as a measure of “investor risk aversion” – the more EPS the better – and the [P/E] as a measure of the price per unit of “investor risk aversion” and when we cast it that way, it is exactly the underlying model of the Capital Assets Pricing Model (CAPM) which is widely used by institutional investors but responds only to volatility and co-volatility which aren’t investment risks but are easily changed or moved because the solution is unstable. (For more information, please see our Post, Earnings Don’t Matter.)

Payless Cashways
Born 1980 Liquidated 2001
With 194 stores across 22 States.

We have no reason to think that Lumber Liquidators is on the same path, or has the same model, or will make the same mistakes as Payless Cashways which was also fast-growing and the virtual inventor of “do-it-yourself” in the 1980s before it got caught up, so to speak, in its financing and equity ownership adventures.

However, we note that Lumber Liquidators is 50% owned by just six institutional investors who individually hold between 6% and 12% of the stock, amounting to between \$100 million and several hundred million of the current \$3.2 billion market value of the company. And that’s enough power to empower the powerless.

Moreover, the deemed [P/E] of 60.5× is nearly three times the demonstrated PEs of companies that are similarly geared, or oriented, such as Home Depot, Lowes or Costco, and that would suggest a stock price of just \$35 and not \$115 in the measured minds of most investors.

But, it takes a lot of money to move a stock price either up or down. There needs to be both buyers and sellers and it would be hard to align the interests of, say, 10,000 investors each with \$100,000 (\$1 billion) to invest in just one company, one side as buyers and the other as sellers but it’s much easier if there are just a few, or a few dozen, each with \$100 million or so. And the company’s earnings don’t have much to do with that. It’s all about ownership and the power to empower the powerless.

However, it’s not hard to see through this. The current demonstrated price of risk is \$60 and rising but the stock price at \$115 is trading as a “free good” which means that there is an excess of demand over supply where, in this case, we’re not talking about “free goods” such as the air that we breath, but the “good” that is “the demonstrated societal standard of risk aversion and bargaining practice” which we can talk about and is meaningful in the context of 10,000 investors but not in the context of six who have the power to decide how much and at what price the stock is traded.

Not To Worry
We know the Price of Risk

But, not to worry. If we know the game, we can play it. Lumber Liquidators has been in the Perpetual Bond™ since much lower prices of \$50 in 2012 (please see Exhibit 1 below, the red line marked Stock Price (SP) which represents ambient stock prices above the price of risk) and we are prepared to buy and hold any stock (regardless of its power) that is trading above the price of risk, with the usual price protections in effect.

Our estimate of the downside in the stock price due to the demonstrated volatility of the stock price, regardless of its cause, is minus (\$15) per share and we can set the stop/loss at \$100 or even more if we’re not too worried about being sold out, or use some of our profits to buy the December put at \$110 for \$4.50 per share. If we sell just five shares for \$575, we can protect the price of 100 at or above \$110 for the next month, or until we have more information or can raise the stop/loss.

Exhibit 1: (B)(N) LL Lumber Liquidators Holdings Incorporated – Risk Price Chart

(B)(N) LL Lumber Liquidators Holdings Incorporated

Lumber Liquidators Holdings Incorporated is a specialty retailer of hardwood flooring in North America. The Company operates as a single business segment, with its call center, website and customer service network.

(Please Click on the Chart to make it larger if required.)

Lumber Liquidators Holdings Incorporated operates as a specialty retailer of hardwood flooring, and hardwood flooring enhancements and accessories. The company provides various wood flooring products, including prefinished domestic and exotic hardwoods, engineered hardwoods, unfinished hardwoods, bamboo, cork, and laminates, as well as resilient flooring products. It also offers flooring enhancements and installation accessories comprising moldings, and noise-reducing underlays and tools. The company markets its products to homeowners or to contractors under the brand name of Bellawood through its integrated sales channels, such as stores, a call center, and a catalog, as well as through its Website, lumberliquidators.com. As of July 24, 2013, it operated 300 retail locations in North America. The company was founded in 1994, has 1400 employees and is headquartered in Toano, Virginia.

For more information on the Chart Elements, please see our recent Post, The RiskWerk Company Glossary.

For more on what risk averse investing has done for us this year, please see our recent Posts on The S&P TSX “Hangdog” Market or The Wall Street Put or specialty markets such as The Dow Transports & Utilities or (B)(N) The Woods Are Burning, or for the real class actionLa Dolce Vita – Let’s Do Prada! and It’s For You, Dear on the smartphone business.

And for more stocks at high prices, The World’s Most Talked About Stocks or Earnings Don’t Matter – NASDAQ 100.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond
Alpha-smart with 100% Capital Safety and 100% Liquidity
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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