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A Shaky Start Does Not a Year Make

(Guest Commentary by Rick Konrad – February 11, 2010)

Dear Subscribers and Readers,

For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick discusses why employment growth will recover sooner than later – as the U.S. productivity growth, strong earnings and cash flows growth continue to recover.  Rick also discusses a couple of stock ideas that still provide value at this point in the cyclical bull market.  This commentary is especially encouraging for the bulls and is a must-read.  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 "Finding Efficiency in Government" 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.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  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 involved with grading 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.


A shaky start to the year does not necessarily command the ultimate outcome for the rest of the year. Though a couple of recent up days has brought the dimensions of this correction to down about 7.2% from the January 19th peak, at worst, given the reactions of clients and other investors, one would think that we have experienced a gut-wrenching walloping and thrashing in the marketplace.  I think there is reason for optimism in U.S. equities.

Part of the rationale for the correction was caused by fears of monetary policy tightening in the emerging markets accompanied by fears of contagion from the Greece debt crisis. In my view, these are unlikely to derail the turning of the fundamentals within the global economy. U.S. net exports continue to surge and have hit their highest levels in 20 years.

Biggest Boom in Net Exports in 20 Yeaers

The most obvious weakness in the US economy relates to the labor market. Productivity growth has been incredible:

Non-Farm Business Sector: Output Per Hour/All Persons

Productivity growth like this, as the chart indicates is quite unsustainable. One wag has pointed out to me that if productivity gains were to continue at this pace, in another 15 years there would not be a single working soul in the U.S., a great example of reductio ad absurdum.

In fact, economic history demonstrates that elevated levels of productivity growth lead to strong employment growth in subsequent periods. In work done by Strategas, let's have a look at employment growth following greater than 2.9% productivity growth since the Second World War:

YEAR Employment Growth 1 Yr Later Employment Growth 2 Yrs Later
1949 3.3% 5.8%
1950 5.8 2.0
1955 3.4 0.9
1959 1.7 -0.4
1961 2.9 2.0
1962 2.0 2.9
1963 2.9 4.3
1964 4.3 5.2
1965 5.2 3.0
1966 3.0 3.2
1968 3.7 0.7
1971 3.5 4.2
1972 4.2 1.9
1973 1.9 -1.7
1976 3.9 5.1
1983 4.7 3.2
1986 2.6 3.2
1992 2.0 3.1
1998 2.4 2.2
1999 2.2 0.0
2000 0.0 -1.1
2001 -1.1 -0.3
2002 -0.3 1.1
2003 1.1 1.7
Average 2.7 2.2

If this long term average holds out, this would translate into 3.5 million jobs in 2010, or about 300,000 a month.

Labor participation, as always will lag. More immediate growth for the economy will come from net exports as we see in our first chart and also capital spending and investment. As you can see, the inventory adjustment has been “off the map.”

Inventories: Cut to the Bone

Let's not lose sight of the strong earnings that have been reported by S&P 500 companies. No longer is it just cost-cutting that is beating consensus estimates, revenue growth is also playing a role:

  Q4-2008 Q1-2009 Q2-2009 Q3-2009 Q4-2009
Percentage beating on top-line (revenues) 33.8% 36.4% 50.1% 59.0% 68.0%
Percentage Beating on bottom line (EPS) 60.1 67.5 72.3 72.3 78.0%
Revs to EPS Ratio of Surprises 0.56 0.54 0.67 0.76 0.87

In addition, the guidance from managements has been very strong. According to Bespoke Investment Group, the spread between the percentage of companies raising guidance and the percentage lowering guidance is at its highest level since 2001. More companies have been raising guidance than lowering for three consecutive quarters.

Quarterly Guidance Percentages
courtesy of Bespoke Investment Group

Perhaps we had gone through a period in the fourth quarter where investors had become quite complacent about investing and expectations had become excessively optimistic. I am finding the recent caving in of investor sentiment against a backdrop of reasonably good earnings news as well as positive guidance to be fairly compelling.

What sort of ideas should be considered? Here's a couple that I am looking at.

Corinthian Colleges (COCO)-  COCO has over  93,000 students and operates 100+schools and offers the full gamut from diploma programs to master's degrees. Corinthian's programs focus on allied health, criminal justice, business, vehicle repair and maintenance, construction trades, and information technology. Roughly 95% of students are in associate degree and diploma programs. There is a potential for increasing regulatory scrutiny from the Department of Education that may affect reimbursement from the DOE based on “gainful employment.” As well, default rates on student loans in some of these schools have been very high, which threatens some colleges with sanctions that could limit the ability to obtain financing for their students. COCO recently reported better numbers for its default ratios than had been anticipated.

Fundamentals remain strong despite this cloud of potential regulation. The demand for education is somewhat contra-cyclical; when the economy turns south, under-employed or unemployed students may upgrade their education or seek new careers. Return on invested capital has been improving and is currently just under 20%. The balance sheet is clean with about $250 million in cash versus about $20 million in debt. However, the company will be using a combo of debt and cash as it completes a recently announced acquisition. EV/EBITDA is less than 4 times. Free cash flow yield is over 15%. I think a reasonable intrinsic value is closer to $18 versus its current $13.55.

Tidewater (TDW)-  Tidewater is  the world's largest fleet of offshore supply vessels for the offshore energy business. With 15% of the world's fleet, about three times its second biggest competitor's share, TDW is a price-taker in an industry where the buying power of the mega energy companies dwarfs that of the suppliers and hence, pricing can be commodity-like.

TDW's best qualities are its balance sheet, which unlike most in the industry sports slightly more cash than debt. For example, Hornbeck (HOS) a fleet that modernized over the last few years derives premier operating margins to TDW, but has a balance sheet with about $740 million in debt, greater than its equity market cap and its $62 million in cash. TDW's fleet, though large is also somewhat older than that of some competitors at about 20 years. TDW is taking advantage of the lull in the energy business to improve its fleet with some new additions. As well, small leveraged competitors will fall away in this difficult period.  TDW is trading at about 5 times EV/EBITDA with its 14% ROIC. In the last twelve months through these difficult conditions, the company has generated about $50 million in free cash flow about one quarter of its 2007 peak. I think intrinsic value here is low $60's versus a current price of $44.36.

Disclaimer: I, my family, and clients do not currently own a position in any of the securities mentioned in this post.

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