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Credit Crunch

(Guest Commentary by Rick Konrad– August 23, 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 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 (Rich was out last week for personal reasons, but he has come back strong this week with a very good and analytical commentary). Thanks, Rick, for writing for us again.

In this commentary, Rick will first be offering his quick thoughts on the current credit crunch, and subsequently, a stock selection within each of the ten sectors of the stock market that he currently likes.  In doing so, Rich has delved deep into each of the firm's balance sheets, income and cash flow statements for us and highlighted each of the firm's strong points.  Not only is Rick's analysis strong, but such an approach (gaining exposure in all ten sectors) will also provide great diversification and protection from sector specific problems.  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 “Recycling” 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.


Credit crunch…hardly new words for old-time investors. Much like a flock of birds or a school of fish that suddenly and without much explanation change their direction 180 degrees, investors, watching the movements of others and seemingly with little communication amongst themselves, have turned direction.

None of this chaos should come as a surprise. A nasty hangover is the inevitable consequence of the excesses seen during a prolonged period of low, long-term interest rates. Relaxation of lending standards has led to turmoil in housing…hardly new news. Relaxation of discipline led to mispricing of risky assets in financial markets. 

Risk-aversion was much too low; the rewards from holding highly risky assets versus the returns of playing it safe with government bonds were much too low. Parties do not go on forever and a misplaced confidence that persistently low interest rates represented a permanent state rather than cyclical also lulled investors into risk la-la land. We have been conditioned by a rather benign period of economic history that had a low incidence of major credit shocks. The Asian crisis of 1997, the Russian crisis of 1998, the collapse of Long Term Capital Management weighed heavily on credit and capital markets in the last decade. The open spigot that the Fed provided post 9/11and post tech bubble helped to sustain global growth and rising corporate profitability. The recent 50 basis point discount rate cut precludes excessive tightening of monetary conditions by making additional reserves available. Don't get carried away in a belief that the Fed is opening a spigot in this most recent move. It is a somewhat half-hearted move to avoid the nasty implications that tightening of credit conditions were threatening. Widespread fire sales of assets that seemed to loom could well have inflicted a fairly substantial negative wealth effect on the economy and resulted in substantial losses to the system. The Fed's move at least temporarily restrained this threat.

Most importantly, what is an investor to do? The present condition is challenging, especially in light of the presence of many hedge funds that are contemplating redemptions and are seeking liquidity. Investment managers are almost Pavlovian in their response by selling stocks that contain the greatest gains, and stocks that have the greatest liquidity. My suspicion is that much of this “Pavlovian” selling has already occurred. Timing the bottom is an art that few of us can do consistently. Henry's guidance in Marketthoughts.com has been remarkable in timing entries and exits from the market. Let's try to compose a buy list of names that we can feel reasonably comfortable with.

The rules of conduct at this point are fairly straightforward: Quality and consistency are the most important hallmarks, free cash flow generation frees businesses from the fickle behavior of capital and credit markets, and finally reasonable valuation on an intrinsic value basis is the key to safe investing. Evidence of effective share buybacks and growing dividends also show managements' attitudes toward shareholders. So here are some selections by sector:

Basic Materials:

NewMarket Corp (NEU) -

Ten years of free cash flow generation.

Operating margins which bottomed on a TTM basis on March of 2005 at 1.53% are now running at 7%.

ROE has improved every year of the last five despite de-leveraging.

ROCE has improved from low single digits five years ago to about 12%

Recently instituted dividend program

EV/EBITDA is 6.8X

Please see the following spreadsheet created by Rick for a detailed analysis of NewMarket's most important financial ratios.

Capital Goods:

Applied Industrial Technologies (AIT)-

Free cash flow positive for the last nine years.

Recently increased dividend by 25% (150% increase over last three years) as well as re-instituted a buyback of 1.5 million shares.

Ten years of de-leveraging only interrupted by 2001 recession.

ROE has shown steady improvement since 2001.

ROA at 11%...remarkable for what is primarily a distribution business.

EV/EBITDA is 8.3 X

Please see the following spreadsheet created by Rick for a detailed analysis of Applied Industrial Technologies' most important financial ratios.

Conglomerates:

3M (MMM)-

Ten years of free cash flow generation and ten years of net reduction in shares outstanding.

Please see Value Discipline link

EV/EBITDA of 8.5 X

Please see the following spreadsheet created by Rick for a detailed analysis of 3M's most important financial ratios.

Consumer Cyclicals:

HNI Corp (HNI)

Ten year history of free cash flow generation interrupted only once (in 1998)

TTM sustainable free cash flow of $2.90 per share

ROIC is 15.4% and interest coverage is almost 11 times. Note, that financial leverage has increased at HNI

Long term history of buying back stock and dividend increases

EV/EBITDA of 7.8 X

Please see the following spreadsheet created by Rick for a detailed analysis of HNI's most important financial ratios.

Consumer Discretionary:

Wolverine Worldwide (WWW)

Eight year history of free cash flow generation.

Debt to capital was 32% at its peak nine years ago and currently is at 3%.

Return on invested capital is 18%.

Significant buybacks of stock since 2002 have exceeded stock issuance.

Five year dividend growth of about 23% as well.

EV/EBITDA of 9.5 X

Please see the following spreadsheet created by Rick for a detailed analysis of Wolverine's most important financial ratios.

Consumer Non-Cyclical:

Diageo (DEO)

Ten year history of free cash flow generation.

Return on capital is 27% and have improved steadily from low teens.

Strong history of share buybacks.

EV/EBITDA of 13.5 X

Please see the following spreadsheet created by Rick for a detailed analysis of Diageo's most important financial ratios.

Energy:

ENI (E)

Return on invested capital is 20%

Restructuring of E&P operations should improve reserve replacement.

Share buybacks have been in place since 2000.

EV/EBITDA of 3.5 X

Please see the following spreadsheet created by Rick for a detailed analysis of ENI's most important financial ratios.

Technology:

Accenture (‘ACN')

Return on capital is 68%

Cash exceeds debt by $2.5 billion.

Ten year history of free cash flow generation …most recent TTM has free cash flow per share of $1.80

A negative working capital company…funded by its suppliers and customers.

EV/EBITDA of 13 X

Please see the following spreadsheet created by Rick for a detailed analysis of Accenture's most important financial ratios.

Healthcare:

Johnson & Johnson (JNJ)

Ten years of free cash flow generation…TTM of $1.59

Cash approximately offsets all long term debt

ROIC of 20%

Net share buybacks since 1999

EV/EBITDA of 11.2 X

Please see the following spreadsheet created by Rick for a detailed analysis of JNJ's most important financial ratios.

Financial Services:

US Bancorp (USB)

Stated policy of returning 80% of earnings to shareholders through share buybacks and dividends.

Exposure to sub-prime appears to be relatively minor (less than 2% of loans)

Strategy of less dependence on interest income and more fee income should improve consistency of results.

Return on assets exceeds 2.0%

Return on equity exceeds 23%.

Dividend yield of near 5%

A Berkshire holding.

Please see the following spreadsheet created by Rick for a detailed analysis of IS Bancorp's most important financial ratios.

Don't let the panic freeze you into inaction. Stick with quality but don't rely on 100% cash.

Disclaimer: I, my family, or clients own positions in each of the above stocks.

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