Mike Tyson and the Economic Punch in the Mouth
(Guest Commentary by Rick Konrad – June 30, 2011)
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 briefly sums up the 2nd quarter performance in various asset classes and sectors—highlighting the glaring underperformance of the energy and materials sectors given the positive sentiment surrounding those sectors and the general fear of higher inflation. Rick again argues for a commonsensical approach—emphasizing the importance of value investing—ending with a value screen encompassing three individual 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 “Don't Look Back in Anger or Forward in Fear But Around in Awareness” for his last commentary). Prior to his 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 after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run 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 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.
“Everyone has a plan ‘till they get punched in the mouth”- Mike Tyson
Despite his ferocious style which included attempting to remove his opponent Evander Holyfield's ear, and a fearsome reputation, Mike Tyson demonstrates some decent understanding of risk management in the above quote.
The second quarter has delivered a number of real sucker punches to investors. Many of the winners of the first quarter, beneficiaries of inflation such as basic materials stocks, as well as energy stocks were down for the quarter. The XME, which is the metals and mining SPDR lost 6.5%. The XLE, energy SPDR was down about 5.3%, the PXE which includes more junior exploration and production names was down 7.6%. The XLF, the financial services SPDR continued to lose ground with a loss of 6.0%. Surprisingly, the consumer discretionary sector as represented by the XLY was among the best performers at +3.3%. Investment grade corporate bonds delivered a satisfying 3.0% as well. Intermediate term Treasuries of 7-10 year delivered almost 4%.
After the sucker punches delivered to the inflationary hedge stocks and commodities in general, and the decent performance of bonds, what message should we be taking? From what I gain ascertain as far as most portfolio strategists, this is the complete opposite of the direction that most have been taking.
Let's get back to the plan despite that sucker punch.
The Economy. Though a lot of people have talked about the potential for a double dip, and God knows, things have been moving like molasses in the last few months, I have a hard time accepting recession as a likely outcome. In all but one case in recent memory, the real funds rate has exceeded 4% prior to every recession. The last recession was the only exception to that rule, since the real funds rate only reached 3%. The level of the real funds rate is a good measure of how tight the Fed is; the higher the tighter. Clearly, the Fed has been doing anything but restricting the flow of liquidity to the economy.
The Yield Curve. An old rule of them has served me well as far as economic outlook. Prior to every recession, the slope of the yield curve from 1 to 10 years was either flat or negative. Like the proverbial canary in the coal mine, a flat or inverted yield curve is a classic sign of tight money, because it is the bond market's way of saying that the Fed is so tight that it will almost certainly have to lower rates in the future.
That deadly combo of a high real funds rate and an inverted curve is what I need to expect that a recession is on the way.
That just ain't what the numbers look like to me.
Slow is decidedly better than down. The forecasts of the last few days from the economic czars have not been encouraging.
The I.M.F. foresees a much less happy and prosperous future for the United States. The fund, in its annual report on the American economy, said growth will not top 3 percent through 2016:
Here is their forecast:
2011: 2.5 percent
2012: 2.7 percent
2013: 2.7 percent
2014: 2.9 percent
2015: 2.9 percent
2016: 2.8 percent
As the I.M.F. notes, a sad corollary is that millions of Americans would remain unable to find work for years to come. The Fed seems much more optimistic, though the message was not handled well by capital markets last week. It said the economy would expand up to 2.9 percent this year, up to 3.7 percent in 2012 and up to 4.2 percent in 2013.
As most of you know, the economic backdrop plays a secondary role for most of us in the value cult. Investors have a very tough time turning off their emotional biases. Even though many investors can accept the fact that decent companies selling at what appear to be cheap multiples represent value, their subjective judgment is tainted by an emotional bias and inaction results.
Here are a few ideas that are cropping up in our screens that we think are looking quite cheap.
Cubic Corp (CUB)
- Five year revenue growth of 8%
- Five year earnings growth of 40%
- ROIC of about 14.5%
- Cash of $300 million versus $15 million in debt
- FCF generation of $100 million in last twelve months relative to EV of $1.1 billion
- Market cap of $730 million plus debt of $200 minus cash of $590 leaves enterprise value of just $340 million.
- Five year revenue growth of 20%
- Five year earnings growth of 6% (acquisitions have not added value, namely Radyne in 2008)
- YTD buyback of 2.4 million shares at $29
- EV/revenue is 0.8X. Honeywell is bidding for competitor at 1.4 X
Hhgreg, Inc. (HGG)
- Five year revenue growth 18%
- Five year earnings growth 9%
- ROIC of 13%
- Mkt cap $530 million plus debt of 0 less cash of $73 million leaves enterprise value of $460 million
- EV = 22% of revenues
- Trades at just 80% of its gross profits
As always, we encourage you to do your own work on these ideas to see if they are appropriate for your objectives.
Disclaimer: I, my family, or clients currently own positions in CUB, CMTL, and HGG.