Let's Be Careful Out There
(Guest Commentary by Rick Konrad – June 21, 2007)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a quick guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. Thanks, Rick, for writing for us again.
In this commentary, Rick will be offering his thoughts on the ever-rising “animal spirits” in the world's financial markets as well as the deterioration of valuations in general – which is further compounded by deteriorating free cash flow generation in many companies listed on the U.S. exchanges. Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “In the Gurus' Footsteps” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
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.
Markets are interesting and challenging, more so than they have been since 2003. The sell-off in government bonds has been triggered by a freshened view of accelerating world growth. Commodity prices, which in many ways are a warrant on global demand, seem to be portraying increased bullishness in the last few weeks.
Henry has been concerned with the equity markets citing liquidity, sentiment, and valuation reasons. The bullish camp still cites the ubiquity of private equity pools, the propensity of corporate buybacks, and continuing global growth as its rationale.
Confusion is rampant in even the highest levels of investment organizations noted for clear, disciplined thinking and great performance. I am referring to Leucadia National Corp (LUK), an organization that has exhibited outstanding wealth creation for 29 years. Reading the annual letter of Ian Cumming, the Chairman and Joe Steinberg, the President casts the sentiment that many of us currently feel (Here is a link to the complete letter):
“These are confusing economic times. There are galvanic economic and political power shifts in the world. China, India and the rest of Southeast Asia are roiling. The U.S. had an economic and political hegemony from the end of World War II until the end of the last century. We are now bogged down in a senseless war in Iraq, the House and Senate are constantly bickering and getting even, and are not able to manage our country. Education, healthcare, Social Security, Medicare, Medicaid, immigration policy, among others, are all difficult issues. We need the best and the brightest, patriots all, to hammer out the thoughtful compromises necessary to assure a prosperous and full future. Will the world ever again look at us as a bright light on top of the mountain? Asia rises and we flounder, where this leads, we know not.”
“One of us thinks the sky is falling and the Dollar on the edge of debasement. One of us thinks the efforts of half the global population who struggle towards the western standard of life and liberty will cause a global bull market that could last a long, long time.”
Henry speaks to the still substantial carry trade as his measure of “animal spirits” and sentiment. Of greater concern to me is the state of credit markets and the potential for drying up of what was an eternal font of liquidity. The CEO of UBS, the Swiss banking group, has warned that the boom in leveraged finance could drag banks into litigation and damaging disputes with clients, if (as and when) the credit cycle turns. Here is a snippet from the Financial Times May 17th, 2007 edition:
“Heady affairs often end in tears. As Anthony Bolton, the UK's most celebrated fund manager, marked the succession at Fidelity this week he sounded a cautionary note about the current relationship between investors and the market. He warned that investors are not differentiating between higher- and lower-risk investments, and private equity groups can borrow on terms that are too lenient.”
“In particular, he highlighted the growth of "covenant-light" loans. Developed in the US over a year ago, these made their first appearance in Europe only very recently. "Cov-lite" instruments look like traditional syndicated loans but lack the legal clauses that allow investors to track the performance of the borrower or to declare a default if financial guidelines are missed. As such, a cov-lite loan is more like a bond, but without a credit rating to reflect the level of risk.”
“In themselves, these loans are just a continuation of the weakening and loosening of covenants already in progress. But they epitomize a more serious concern: the voracious desire for deals and loans that is the result of excessive liquidity. Another sign of this appetite is the emergence of bridge equity. This involves banks that are lending to private equity taking on a temporary equity commitment to facilitate a takeover, and selling it on to other investors on completion.”
“Alongside this pressure to do deals is a worry that banks have less to lose than in the past from relaxing their standards. If they are selling on leveraged loans rather than keeping them on their own books, then the creditworthiness of the borrower becomes someone else's problem. The Bank of England warned last month that transfers of credit risk could make a financial crisis more likely.”
The “daisy chain of risk transfer” has been highlighted in Marketthoughts' discussion of the collapse of the Bear Stearns' High-Grade Structured Credit Strategies Enhanced Leverage Fund. The notion of high-grade which may have beckoned creditors' participation initially seems to have escaped them as the bidding for the remaining assets proceeds. With the shoring of $600 million in partners' capital, creditors lent on a 10 to 1 basis funding an additional $6 billion in lines in assets. The forthcoming auction may provide a rude awakening as the clearing price may well fall below the “fair market value” that hedge funds' valuations ascribe to these assets.
Let's talk a bit more directly about equities themselves and the elements of their valuation. Anecdotally, there are a few developments on the scene that are becoming a little worrisome. A corollary of the “global growth is continuing” argument is that increased sales and growth of earnings are the standards of success. But valuation goes much deeper than that, the ultimate test of corporate success and strategy is whether it creates economic value for shareholders.
A little review of finance to begin. From first principles we recognize that the value of any company is a function of the Present Value of future cash flows, a Buffett principle if ever there was one, and certainly the basis of most EVA Theory and corporate finance.
Operating Income (1)
= EBIT after Taxes
Plus: Depreciation and Amortization
Less: Capital Expenditures (2)
Less: Changes in Working Capital (3)
= Unlevered Free Cash Flow
The main drivers of free cash flow are as simple as (1), (2), (3), essentially operating margins, the intensity of capital expenditures, and the investment in working capital.
Discounting these future free cash flows back to the present depends on the cost of capital, a cost which moves directly with the cost of borrowed money. Needless to say, the sell-off in government bonds over the last few weeks suggests that a higher discount rate is needed to reflect the cost of money. That in itself is disturbing, but there is more.
As you can see from my calculation of unlevered free cash flow, the combination of downward pressure on operating margins, increased capital expenditure needs, and increased working capital needs put downward pressure on valuation.
A recent Wall Street Journal article of June 19, 2007 (subscription needed) highlights “Companies Fall Behind in Cash Management.” The article suggests that large US companies are stalling in their working capital management and becoming inefficient. As the article indicates:
“Reducing working-capital needs can lead to significant improvements in a company's overall cash flow. And strong cash flow can boost a company's return on assets -- a measure of a company's ability to generate profit and earnings growth through the use of its assets and investment. Reductions in working capital over the past several years have helped buoy stock-market valuations.”
The survey of working capital utilization trends is compiled by a consulting firm, Hackett Group- REL and is published in CFO magazine. Their most recent published survey was last year, compiling year-end 2005 results and showing that for the fourth year in a row, working capital management had improved. Not so this year. Though the results have yet to be published, the WSJ article suggests that inefficiencies are creeping into the system.
I thought it would be useful to pinpoint all three elements of free cash flow generation in order to screen some companies where all three factors were deteriorating i.e. operating margins were falling, working capital intensity was increasing, and capex was increasing. I applied my screening to S&P 1500, the composite of the S&P 500, the S&P mid-cap 400, and the S&P Small cap 600. Only non-financial companies were considered.
[Henry's note: Rick has graciously provided a Google spreadsheet link to the list of companies that fit these three criteria, as follows. The list was too big to post on this commentary]
This is not a list of short candidates necessarily. Many of these companies, despite the one-year deterioration in operating margins or the increasing investment, the market may be mis-pricing some of these names, in either direction. In fact, check the disclaimer…I, my family, or clients may own some of these stocks because in my opinion, they represent value. But in aggregate, there's a lot here that could go wrong. The aggregate price to free cash flow based on trailing twelve months numbers is 69.2 times representing a free cash flow yield of only 1.45%. At an average 48.51 times operating cash flow (NOT earnings but operating cash flow), there is a lot to be consider.
Exercises like this represent only an opening salvo in your analysis. A more complete understanding of the working capital dynamics and competitive industry dynamics will tell you a lot more about the reasons that valuation should be under pressure. The deterioration could represent a short-term phenomenon reflecting a recent acquisition, or it could suggest something more difficult and deep-rooted.
Finally, the appropriate discount rate used to discount these cash flows must be chosen carefully. I am modeling companies based on a base case of 6% government bond yields plus a risk premium that is determined by the volatility of the cash flow stream and the quality of the balance sheet. Is 6% too high a base case? Better safe than sorry.
And that is my bottom-line here. I am still finding companies that are worth buying (at least I hope so!) But the “wall of worry” that many people are willing to clamber has a lot of chasms in it. The “animal spirits” certainly seem to be there in spades when we look at the Blackstone IPO now reportedly six times over-subscribed despite the great uncertainty about the firm's taxation and pro-forma compensation assumptions. As one observer cites, “If you have enough orders there's no point in waiting.”
Bill Gross at Pimco may well be onto something as far as seeing a 25-year bull market in bonds drawing to an end. The effect on the cost of capital is obvious.
Finally, our little exercise on the (1), (2), (3) of corporate finance. When those three factors turn south, you better know why and what impact it has on valuation.
Like they said on Hill Street Blues, “Let's be careful out there!”
Disclaimer: I, my family, or clients have a current long or short position in Amgen, Becton Dickinson, Bed Bath and Beyond, Chattem, Compuware, Fiserv, Foot Locker, Furniture Brands, Global Payments, Jones Apparel, Lexmark, Mentor, Merck, Pharmaceutical Product Development, Southwest Airlines, TTM Technologies, and Yahoo.