Keeping the Faith Despite the Noise
(Guest Commentary by Rick Konrad – November 11, 2011)
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Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick kindly reminds us of the various day-to-day distractions that our minds tend to tune in—sometimes with detrimental impact on our portfolios. Rick keeps us focused on what matters most—free cash flows, valuations, and having an appropriate contrarian streak. Given the high cash flows and ROEs enjoyed by U.S. companies, long-term investors (which all of us should be) should now be purchasing stocks. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “The Unknown Unknowns” for his last commentary). Prior to founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts. Rick is a very genuine teacher of the financial markets and treats his role very seriously. Rick has also run the education program for the CFA Society in Toronto (which is the world's third largest CFA society besides the New York and London Societies) and had graded CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
It's been a long time since I last appeared in Marketthoughts. Personal and family issues have taken a lot of time and I apologize for my absence and thank you for your patience. Markets since I was last here in September have tried our patience as well.
About a year ago September, I had written about the remarkably poor sentiment that existed at that time. Allow me to reprise a few comments that I had made at that time.
“However, the beginning of September seemed to mark a bit of an inflection point in the stock market's fortunes. Fears of September and October crashes of the past (how often have we been told that these are the worst months) set us up for a nice bounce. Sentiment has been horrific…so bad that even Mary Shapiro of the SEC made some noteworthy comments about individual investors distrust of markets just last week in a speech to the Economic Club of New York:”
“Particularly as this may relate to the May 6 “Flash Crash,” the SEC is continuing to “address weaknesses” in market structure that could have contributed to the severity of the May 6 volatility. There has been a related loss of investor confidence in the markets as a result of the crash. Schapiro said that “retail brokers dealers have told” SEC that “individual investors have pulled back from participating in the equity markets since May 6.” What's more, the chairman pointed to an outflow from retail mutual funds, “every single week since May 6.”
Once again, the rapid collapse of MF Global into bankruptcy has alarmed many investors. The history of the firm pre Jon Corzine was quite sordid. An analysis of regulatory enforcement actions shows that the firm had drawn more sanctions from the commodity futures regulator than each of its 14 closest peers in that market over the past decade. MF Global has also drawn the second-highest amount in fines, for alleged lapses in risk supervision and recordkeeping. None of the violations took place under Jon Corzine's watch since 2010. What appears to have brought down the firm was lax risk management controls and Corzine's reckless bravado in attempting to call the European sovereign debt market on a highly leveraged bet.
It is easy for us to get caught up in the stat of the day game, what someone has described as “drive-by investing.” When one loses perspective of a longer term horizon, one can get dragged into assigning far too much importance in the relevance of today's statistic or news item. Generally, the information content that can be derived from a single data point tells us essentially zero about value, a significant portion of which relates to future cash flows rather than looking backward. Also, the daily barrage of political news regarding European events also should have little bearing in assessing most of our investments. In some ways, this reminds me of drivers who slow down to look at an auto accident scene. There is a ghoulish curiosity that causes these slowdowns and jams yet few of us benefit from whatever information or sights that we gather as we pass by. Similarly, investors' attention when misdirected at some European parliament is a diversion rather than incremental information.
Our approach has always emphasized the selection of individual securities that we believe to be sensible and reliable. We continue to avoid broad brush comments about aggregate market valuations, macroeconomics, and politics. We continue to find a few securities where we believe that their valuation dismisses any future prospects. Systematic approaches to buy what “smells” as a contrarian often provide superior returns.
We had described one of the systematic approaches last year that was developed by Benjamin Graham many years ago as his “Enterprising” selection. Using relatively simple criteria such as current assets having to exceed current liabilities by 50%, restrictions as far as total debt, and constraints re: price to tangible book, it is fairly easy to build some interesting screens.
Here is the article from a year ago with the screen: zs20100909.html
The criteria are fairly simple and far different from the quality that I ordinarily would demand. As most of you know, we do prefer companies that generate high returns on capital. We generally insist on companies that have a history of generating free cash flow. Free cash flow is particularly important at these times when banks are reluctant to lend and financial flexibility is prized. In addition, free cash flow generators can not only reinvest in the business but can develop growing dividend streams and buy back stock. This rather motley list of names had few of these characteristics.
Despite the somewhat motley list, an equal dollar portfolio invested in these names generated a return of 16.6%. This compares to the 14.3% return of the benchmark Russell 2000. The S&P returned 14.9% over this period.
More than one quarter of the securities generated returns in excess of 20%; the best names produced returns of 71%, 86%, and 96%. The worst results were losses of 8%, 14%, and one whopper of 47%. Remember, we applied no quality criteria to improve the selection.
Our point is that rather than using market volatility as an excuse to run and hide in the supposed shelter of bonds or cash, an unmanaged portfolio of equally weighted stocks run from almost 80 year old criteria produced outperformance of the market index and an absolute return of almost 17%. That's despite Greece, Italy, tsunamis, and a going nowhere super committee!
In our most recent post, we had written:
We tend to extrapolate from the most recent past or from vivid events, and what many investors fear is another Lehman kind of an event. As Meir Statman, the famous behavioral psychologist pointed out recently in a Morningstar interview: “We just feel down, and so we tend to extrapolate from the past. And again, studies, what we know from science, what I know from my own work is that, while we tend to extrapolate from the past, thinking that low returns portend low returns in the future, in truth the opposite is the case--that on average, pessimism and fear are actually followed by relatively high returns rather than low returns.”
Do you believe that current conditions in the U.S. and global markets are conducive to high levels of M&A activity? In a recent survey of MBA students that I had conducted, fewer than 20% believed that this was a good time to be going into M&A.
I happen to believe that current conditions in capital markets are conducive to high levels of M&A activity. Following the upheavals induced by the financial meltdown of 2007-2009, I believe that most of us are gaining a new pragmatic understanding of economics. Capitalism has an irrevocable instinct for self-preservation in my opinion. Though I may be accused of deluded wishful thinking, my reasoning is based on Adam Smith's arguments that the "invisible hand" automatically coordinates the actions of individuals pursuing their own self-interest so that they satisfy each other's needs, despite the fact that no one is thinking consciously about the common good. As Buffett has recently suggested, it has been a losing bet not to be optimistic about the future of this country. Consequently, I remain comfortable with the notion that we will continue to "see" economic growth globally.
The unending litany of negative news from Europe and much hand-wringing Stateside has had a sobering, but not a dulling effect on M&A. We likely will abandon the very speculative leverage and EBITDA multiples that were paid prior to the crisis, but long term survival of any corporation depends on its continued ability to develop success in achieving competitive strengths. Under whatever economic conditions may exist, companies must shift resources from well-established mature businesses to emerging business activities with growth potential. Broadening the product and or service spectrum is one of the important hierarchy of drivers for M&A.
Despite the negativism around us, US corporate profitability remains strong (Source: St. Louis Fed: http://research.stlouisfed.org/fred2/series/CPROFIT)
US corporations are remarkably liquid. Note that with assets stated at replacement value, financial assets have been greater than equipment, real estate, and inventories (real assets) since 2009. (Data from Federal Reserve Flow of Funds Accounts as of Second quarter September 16th, Z1 report.. http://www.federalreserve.gov/releases/z1/current/z1.pdf)
Focusing on cash flows, the capital intensity of American business is also very low relative to the last decade, though trending up slightly (Cash Flow Trends and Fundamental Drivers Qtr2, 2011, courtesy Charles Mulford Georgia Tech—this covers all US public companies with market caps > $50 million, about 3,000 companies)
As Mulford reported on other elements of free cash flow for this large sample:
"During the June 2011 reporting period, companies continued increasing investments to support growth. In particular, inventory days increased to 24.00 from 23.14 in March and accounts receivable days grew to 53.12 days from 52.80 in March. Capital expenditures were also increased, rising to 3.16% of revenue in June 2011 from 3.01% in March."
"In the twelve months ended June 2011, median revenues began to show a noteworthy improvement, increasing 14.90% to $633.57 million from $551.41 million in March 2011. Free cash flow also turned up in the June reporting period, increasing 4.23% to $21.60 million from $20.72 million in March."
Turning to the largest companies of the S&P 500, we see continuing progress in profitability and free cash flow generation (data courtesy of Oppenheimer Asset Management- November Chartbook, Nov 8, 2011)
Prior merger waves have occurred (almost lemming like) during sustained periods of high economic growth, low or declining interest rates and a rising stock market. In my opinion, even in periods of relatively slow economic growth as most foresee, the need for achieving operating synergies, the need for strategic realignment to adapt to relatively slow growth, and the need for greater globalization will continue to drive M&A.
Finally, recent trends globally support my bullishness for continuing M&A activity. According to mergermarket.com's third quarter press release
"Global M&A for the first three quarters of 2011 totaled US$ 1,718bn, up 21.5% from the same period in 2010 (US$ 1,414.4bn), and was the busiest Q1-Q3 period since 2008 when the same period saw US$ 1,949.4bn-worth of deals. 8,930 deals were announced for the year to September, six deals more than Q1-Q3 2010."
"The average premium (one day before) paid globally on M&A deals in the first three quarters of the year increased to 23%, up from 22% in 2010 and at its highest since 2009 when it was 25.5%. European premiums, averaging 20.5% in the first three quarters, reached their highest since 2008 (when they averaged 22.9% for the full year). Meanwhile premiums for North American companies, at 34%, were higher than 32.7% seen in the same period in 2010, though still well below 2009's 42.4%. In the Asia-Pacific region, Japanese premiums averaged at 29.5%, at their highest since 2008 when they were 41.2%."
Though the economy may be meandering, we continue to believe that we will continue to find some reasonably priced companies in this environment. Last time, we had suggested that we were “nibbling” at BASF and ITW. BASF is up 14.7% in these two months and ITW is up 9.1%, matching the S&P's 9.1% advance over that period.
Keep the faith.
Disclaimer: I, my family and clients have positions in BASF and ITW