What’s Happenin’

Over the past three weeks I’ve reviewed approximately two hundred earnings reports and conference calls. While very time consuming and exhausting, my quarterly earnings routine is an essential part of my investment process. With an up-to-date summary of where we are in the profit cycle, I’m better able to normalize earnings and more accurately value the small cap companies I’m considering for purchase.

Although I’m bearish on small cap prices and valuations, I do not believe the U.S. economy or corporate profits are currently in recession. While second quarter operating results were inconsistent and varied between industries, on average, sales and profits increased modestly. In my opinion, Q2 2017’s results were similar to Q1 2017 and were commensurate with a slowly growing economy – a trend that has been in place since Q3 2014 (interestingly the end of QE3 was announced in October 2014).

Based on the operating results of my opportunity set, I continue to believe the U.S. economy is growing in the low single-digits. Last quarter I stated Q1 GDP growth of 0.7% appeared low (was recently revised to 1.2%). At 2.6%, Q2’s GDP growth looks a little high in real terms. However, on a nominal basis, the mid-3% growth reported in both quarters appears reasonable. To get a more accurate measurement of real GDP, I suggest averaging Q1 and Q2, which puts real GDP growth slightly below 2% and more in-line with my bottom-up observations.

Below is a summary of several business trends I noticed during the quarter.

  1. Consumer companies, on average, continue to report sluggish operating results. Most volumes and comparisons remain low single-digit positive to negative. Strategies to combat weak volumes and traffic vary, with some consumer companies turning to promotions, while others are reducing inventories and increasing price. Regardless of the strategy, it’s an extremely competitive environment with companies fighting tooth and nail to protect market share or margins (tough to protect both). On the bright side, quarterly comparisons are getting easier (it’s been almost a year since I noticed the consumer slowdown: Consumer Alert). Furthermore, inventories are tightening, which should stabilize margins and reduce the risk of further destocking. However, lower inventories and fewer promotions may also lead to higher consumer prices.
  2. Despite reports of tame consumer and producer inflation, many businesses reported cost pressures and pricing action in Q2. I’m not certain if or when these increases make it into the government data, but I listed dozens of examples of cost and price increases in my quarterly management commentary write-up (available upon request). Although inflation isn’t spiking higher, it was definitely noticeable in Q2 and certainly isn’t dead (as the bond and equity markets have priced in).
  3. Industrial businesses, on average, had a good quarter. Companies tied to construction and aerospace/defense reported healthy results. A rebound in energy spending also contributed to improved results. However, the benefit from energy should moderate in Q3 and Q4 2017 as comparisons get more difficult (rig count troughed at this time last year) and the direction of energy investment is less certain.
  4. Investment in domestic energy infrastructure rebounded again in Q2. Barring further declines in energy prices, most energy companies appear comfortable maintaining 2017 spending. However, rig count growth is moderating sequentially, so expect growth to slow in Q3 and Q4. 2018 remains very uncertain as most capital expenditure decisions are on hold – energy companies are in wait and see mode. And finally, offshore remains very weak with no rebound expected.
  5. Auto manufacturing is declining slightly. Most companies aren’t predicting a major decline, but there doesn’t appear to be strong conviction on future trends.
  6. Agriculture remains challenging, but seems to have stabilized at lower levels.
  7. Transportation volume and pricing appears to be improving modestly. Weakening dollar could help rails/exports.
  8. Financials are doing well on average. Loan losses at banks are manageable. Insurance may be a bigger trouble spot at the end of this cycle than banking. I believe there is a growing risk insurance companies are underwriting too aggressively to maintain premium growth. And of course their investment portfolios are tied to the bond and equity markets to different degrees.
  9. Technology results and trends mixed. I need more data.
  10. Currency was not a major factor in Q2.
  11. Outlooks and commentary suggest Q3 2017 should be similar to Q2, or what we’ve seen since mid-2014 – slow aggregate growth, with the dispersion between industries continuing.
  12. Certain companies and sectors, such as consumer staples and technology,  appear to be getting a pass on earnings misses, while others such as consumer discretionary and energy are not. It’s as if investors are normalizing operating results for some businesses, but not all. This is just an observation on sentiment and conformity (possibly exaggerated by ETF and passive investing – what’s working or popular are larger weights in benchmarks which benefit more from investment flows into passive). I do not have supporting data on this – again, just an observation.

As always, if you’d like to read some of the management commentary that helped form my macro opinion, please shoot me an email. It’s a little longer than normal this quarter (over 50 pages) and was too lengthy to post.

In addition to financial and macro related commentary, there is always plenty of other interesting and entertaining content on quarterly conference calls. In fact, I learn something new every earnings season. For example, as it relates to long-term economic growth, I found Church & Dwight’s (CHD) comments related to their TROJAN division very relevant and interesting. In effect, are smartphones contributing to the decline in population growth and household formation?

Church & Dwight’s management explains, “The condom category declined in consumption by 3% in the quarter. TROJAN condom share in measured channels was down 150 basis points. Although some of that is offset by online consumption — condom consumption, all channels has been soft for the last few quarters. Our research suggests that young people are having less sex. Some of the factors are demographics, young people living at home longer, and surprisingly, the distraction of mobile phone usage.”

If young people are having less sex due to the distraction of their smartphones, is it safe to assume they’re doing less of everything? If so, this could help explain why consumer demand for many products and services has been weakening. Instead of shopping, eating out, or attending a sporting event, maybe a growing number of young consumers prefer spending their time “non-GAAPing” their Facebook page (presenting your life without bad things) or watching episodes #54-#58 of Breaking Bad on Netflix!

Counting Boxes

I continue to plow through earnings season and will hopefully finish in the next week or two. At that time I’ll put together a summary of what I’m seeing within my 300-name opportunity set. Although my review isn’t complete, I’m noticing a few interesting trends.

As the Federal Reserve and bond market remain fixated on statistics suggesting disinflation, signs of rising costs (including labor) and pricing power are appearing in Q2 earnings reports. I thought Sonoco Products Company’s (SON) second quarter results and management commentary were particularly interesting.

Founded in 1899, Sonoco is a leading manufacturer of industrial and consumer packaging. It’s a relatively simple business with a long operating history and respectable track record. Selling at 18x 2017E earnings, Sonoco‘s valuation isn’t cheap, but it’s less expensive than most of the high-quality equities on my possible buy list. In my opinion, Sonoco’s relatively subdued valuation is a result of slow earnings growth. For the year Sonoco expects EPS of $2.73 to $2.80 versus $2.72 in 2016.

During the second quarter, Sonoco’s gross margin was under pressure due to declining volumes and rising costs. SG&A was also higher, partially due to wage inflation. In an attempt to offset higher costs, Sonoco is raising prices. In fact, higher prices contributed 4% to sales growth in Q2, while volume and mix subtracted 1.9% (total sales growth was 3%).

Commenting on sales and volumes, management said, “One of our toughest challenges right now is dealing with generally weak demand from many of our Consumer Packaging customers. This isn’t new. Consumer Packaging volumes have been flat to down since the end of 2014 as consumers’ preference for packaged food is clearly being impacted by changing taste for more fresh and natural products.”

Sonoco is in a tough spot with declining volumes and rising costs. The rising cost of OCC (old corrugated cartons – used in recycling) has been particularly noticeable. According to management, OCC pricing in the Southeast averaged $165 per ton versus $87 in the same quarter last year. On their Q2 conference call management commented, “As most of you know, Sonoco is a significant recycler and consumer of OCC. The cost of OCC reached historic levels in March, then declined in April and May but has now pushed back to record levels of $185 a ton in the Southeast.”

What is causing the spike in OCC prices? Management believes e-commerce may be a possible contributor. Specifically, the OCC supply from retailers, or as management calls it, “what’s available behind the stores,” may be in decline. As e-commerce grows, the number of boxes carrying merchandise directly to homes is increasing, which reduces the number of boxes sent to retailers. Considering the collection process of OCC from stores is more efficient than from homes, it’s reasonable to assume less OCC is finding its way into the recycling supply chain.

Management explains, “One of the things that is still confusing me, and I must say this, is e-commerce isn’t new. It’s been here for some time. What’s so unique about this particular year? I think that we really need to get our hands around that. We’re working internally to better understand it. AF&PA [American Forest and Paper Association] is also working to understand how you improve recycling rates through the home — through homes versus behind the stores.”

As the industry determines how to recycle OCC from homes more efficiently, Sonoco isn’t sitting still and is responding with higher prices. Management believes they are early in the process and are “going to go for recovery.” Sonoco isn’t alone. Management states, “These are real increases, every one of our competitors. No one’s not receiving these cost increases. So I remain fairly confident that our competition understands the magnitude of the increase that’s hitting them, and we’ll react accordingly.”

I find all of this very interesting. While the structural shift in retail may be having an impact on OCC prices, what about shifts in store inventory and consumer demand? When I started as a buyside analyst, I remember retail analysts would visit shopping centers and count cars in parking lots as a way to measure consumer traffic and demand. Today, instead of counting cars, maybe it would be more useful to go behind stores and count the stacks of empty boxes waiting to be recycled! Based on OCC pricing, I wouldn’t be surprised if they found fewer boxes than a year ago.

Despite all of the attention deflation and disinflation have been receiving, there are clear examples of rising costs and pricing power in recent earnings reports. As a patient absolute return investor, I view inflation as one of the many potential catalysts for future opportunity. Put simply, what happens to central bank asset purchases and the Fed put once inflation reaches a level similar to Sonoco’s pricing power (4%)? They vanish along with the belief profit and market cycles are a thing of the past.

The Third Time is the Charm

It’s been ten years since the housing and mortgage bubble began to unravel. While the exact date is debatable, I remember July 2007 as a very important month. It was when Bear Stearns announced two of its funds holding subprime mortgages lost most of their value. Shortly after, the marginal buyer or borrower discovered it would become more difficult to obtain a mortgage. It was the beginning of the end for the housing bubble and the 2002-2008 market cycle.

The housing bubble was an important time in my life and career. As home and stock prices soared, I was again forced to invest very differently from my peers and benchmark. As a result, performance lagged throughout most of 2003-2006, while the credibility I gained during the previous cycle began to fade (apparently past bubble cred is nontransferable!). I went from being one of the portfolio managers who got the tech bubble right, to the manager who was getting the housing boom all wrong.

Although my positioning and message wasn’t very popular, I tried to convince as many people as possible that we were in a bubble. The first person I tried to convince was my wife. Our modest house in Florida appreciated 55% in only two years! I wanted to sell before the bubble popped, but wasn’t sure if my wife would agree.

Initially she thought I was nuts. “We just bought the house,” she explained. “You’re right, but these gains aren’t real – it’s all one big bubble,” I argued. While you won’t hear this from Dr. Phil, one of the keys to a successful marriage (and parenting for that matter) is mastering the art of bribery. After doing some cost/benefit analysis, I bribed my wife with a deal I thought she’d buy into – and she did! Our house sold almost immediately.

After we sold and began to rent, home prices continued to march higher. I couldn’t help but wonder if we (or I) made a huge mistake. Our rental was near the beach where the market was booming. Living in a real estate hot spot was a constant reminder of my poorly timed decision to sell.

My neighbor bragged to me about how he just paid off his car with his home equity line. A friend told me how much he was making on his third investment property. A banker literally laughed in my face as we debated the merits of housing. “You’re throwing your money away by renting,” he said. It was a difficult time to be a renter and nonbeliever in the perpetual housing boom.

Despite the seemingly endless real-time data points suggesting I had lost my mind, I firmly believed the economy, stock market, and housing market were all one giant bubble built on unsustainable credit growth. I was confident in the facts and my analysis. All I needed to do was be patient and survive the constant narrative from the media and financial markets that I was wrong and this time was different (sound familiar?).

In addition to selling our house and renting, I avoided bank stocks and allowed cash to build. Furthermore, I was careful not to extrapolate peak earnings of cyclical and consumer companies benefiting from the easy credit environment. Given how credit spilled over into many areas of the economy, profits for most industries were high and growing. Instead of normalizing profit margins and cash flows, investors appeared to be valuing businesses as if the good times would never end.

As a strong believer in economic, credit, and profit cycles, I was confident the excesses of the boom would ultimately result in a bust – it was only a matter of time. In addition to attempting to protect myself and clients from the risks of the housing bubble, I continued to spread the word to anyone who would listen.

I’ll never forget the day my wife and I were riding bikes and I noticed a realtor escorting buyers into a new luxury condo. Suddenly and unexpectedly, I yelled, “Don’t do it, it’s a bubble!” The look the realtor gave me was priceless! And my poor wife was so embarrassed, but not me. I laughed and laughed all the way back to our rental.

Of course, the end of the housing bubble wasn’t funny. When it imploded millions of people were hurt and many institutions failed. Just as with today’s asset inflation, the last cycle’s excesses were founded on easy money and the widely-held belief that prices would never be allowed to fall. There are many similarities this cycle versus last cycle and the cycle before it.

Given the parallels between the current market cycle and the past two, it’s logical to ask if we’re currently in another bubble. Depending on your preferred valuation measure, equities are as expensive (more expensive on some measures) than they were in 2000 and 2007. If valuations are similar or higher than past bubble peaks, how can today’s cycle not be considered a bubble?

Regardless of how the current market cycle is labeled, I’m confident my opportunity set is the most expensive it has ever been, including 2000 and 2007. As such, I’m comfortable calling small cap stocks a bubble, but more important, I’ve positioned myself accordingly.

While selling our house and renting worked very well during the last bubble, this cycle I’m more focused on avoiding overvalued equities than overvalued real estate. Although home prices currently appear expensive locally, I haven’t bribed my wife to sell our house again. There are several reasons. First, the only bribe she’d accept today would be moving into a bigger house! Second, we have kids now which makes moving less practical. And third, given the broadness of overvaluation this cycle, our investment positioning is different with a larger allocation to liquidity and patience.

Considering the potential risks of central bank asset purchases, I continue to believe holding some form of hard asset, such as real estate, makes sense (at least in our situation). Once earnings season concludes, I plan to write a post discussing one or two asset heavy companies on my possible buy list that may be interesting cash hedges. I recently bought one, added another to the list, and continue to consider others I’ve owned in the past. Having a barbell portfolio consisting mostly of liquidity and patience, combined with a cash hedge, or central bank insurance, seems rational to me. And if I can find a cash hedge trading at a discount to its net asset value, that’s even better. More to come in the following weeks…

Have a great weekend!

 

Coin Flip Investing

Have you ever worked on a stock and came to the conclusion it could either double or go to zero? I have and I did again last week. In an effort to limit mistakes and maintain an attractive batting average, as an absolute return investor, I try to avoid coin flip investing. During my resent search for discounts in the energy sector, I discovered the industry was filled with potential coin flips. CARBO, the market leading ceramic proppant manufacturer in the oil and gas industry, is a good example.

What’s worse than being in a commodity business? Selling a commodity to a commodity business. While I’m certain CARBO would argue most of their products are proprietary, they compete with a commodity known as sand. As energy prices declined in 2014-2016, energy and production companies looked for ways to reduce finding and development expenditures. In their effort to lower costs, many energy companies increased the use of sand in their fracking process. Furthermore, less expensive imported proppants were also threatening market share. In effect, CARBO faced stiffer competition from lower cost providers at the same time energy exploration budgets were being slashed. It was a devastating combination.

Prior to the bust, oil was trading near $100/bl (2011-2014), with exploration and production companies focusing almost exclusively on production growth. As oil prices traded well above all-in costs, companies were willing to pay for higher-end proppants to maximize production. Elevated oil prices also made higher cost reserves at lower depths economical. This benefited CARBO as their proppants are more effective at lower depths (higher pressure) than sand and lower quality proppants.

As Wall Street flooded the energy industry with cheap capital, the race to grow production was on – CARBO’s business was booming. Due to surging demand, CARBO expanded capacity aggressively with capital expenditures far exceeding depreciation during the boom years. CARBO was a popular growth stock, reaching $180 in 2011! Earnings also peaked in 2011, with EPS reaching $5.62 (CARBO is a good example of investors confusing cyclical growth for sustainable growth). Currently trading at $7/share and losing money (-$3.29 EPS in 2016), CARBO has seen better days.

Fortunately for CARBO, revenue trends are beginning to recover. With capital budgets and rig counts in North America increasing, the demand for proppants is improving. Recent results from the major service providers (SLB, BHI, and HAL) and CARBO confirm this trend. The below quotes are from last quarter’s earnings reports and conference calls.

Halliburton (HAL): “North America activity increased rapidly during the first quarter, which was highlighted by our U.S. land revenue growth of nearly 30%, outperforming the sequential average U.S. land rig count growth of 27%.”

Baker Hughes (BHI): “The ramp-up in North America has been more robust than many had expected. Along with this growth, we’ve had to work through the challenge of supply chain tightness, with labor and materials cost inflation [would include proppants] impacting select product lines and basins.”

Schlumberger Limited (SLB): “The recovery will clearly be led by North America land, where investment levels are expected to increase by 50% in 2017, leading to a strong increase in activity and an overdue correction to service and product pricing.”

CARBO Ceramics (CRR): “Given the first quarter revenue and our outlook for the next couple of quarters, we believe our 2017 revenue will show strong double-digit growth of at least 40% increase over the 2016.”

With CARBO’s net assets selling significantly below replacement value and its business trends improving, why wouldn’t I consider buying the equity? Unfortunately, in my opinion, CARBO possesses both financial risk and operating risk (disqualifies CRR as an absolute return holding). With $56 million in cash and $109 million in net working capital, the company should have adequate liquidity this year. Furthermore, the majority of its $73 million in debt was recently refinanced out to 2022.

While CARBO should have sufficient liquidity for 2017, if its cash burn rate remains negative (possible if energy cap ex budgets are cut), liquidity and financial risk could increase and is a concern. The company burned $24 million in cash in Q1 2017 after a $13 million negative free cash flow drain in Q4 2016. As you can see, at current rates, it wouldn’t take long for CARBO to spend its remaining cash and run into liquidity issues. Fortunately, management expects the company’s cash burn rate to improve sequentially and exit 2017 at a neutral rate (we’ll know more next week when CARBO reports earnings).

Given CARBO’s balance sheet risk (liquidity relative to cash burn) combined with its extremely cyclical business, it’s not an appropriate investment for my absolute return portfolio. That said, I’ve been pondering if several energy stocks, such as CARBO, would be worthwhile “coin flip” speculations for option strategies – owning puts and calls. In effect, a position that would pay off if things go great or awful (I’m expecting one or the other for CARBO). I’m certainly not an option expert (I often get the idea right, but the timing wrong!), and it would clearly be a speculation, but I think it’s interesting to think about nonetheless. As a side note, you know your opportunity set is bad when you’re contemplating ways to profit from a coin flip!

In conclusion, my search for value in the small cap energy sector has generated several possible buy ideas. While I believe there are many energy companies selling at discounts to net asset values, most balance sheets appear ill-equipped to handle an extended period of depressed commodity prices. In other words, there is value in energy, but is there sufficient liquidity or time for that value to be realized? Until balance sheets improve, I expect to find more coin flips in the energy sector than investments that meet my buy criteria for cyclical businesses.

Top Absolute Return Investing Posts

A little over a year ago I recommended returning capital to clients as I believed my opportunity set was too expensive to meet my absolute return investment objective. As a way to remain engaged in the markets and stay on top of my 300-name possible buy list, I decided to start a blog. This week marked the blog’s one year anniversary!

After 155 posts, I’ve practically written a book on absolute return investing and the current investment environment. I’ve enjoyed it considerably and plan to keep going until this seemingly endless market cycle is complete.

This week is also my one year anniversary of unemployment. Considering the unemployment rate is at a 16-year low, not having a job these days truly is contrarian! It took me a few months to detox from the markets, but it’s been a very good break. I’d like to thank all the central bankers for their $12 trillion in asset purchases and negative real interest rates. Without their relentless devotion to monetary experimentation and record asset inflation, I’d probably still have a job!

In all seriousness, it’s been a good year. I want to thank everyone for reading and helping me remain involved in what has to be one of the most fascinating cycles in the history of financial markets.

If you’re an absolute return investor – even if you’re trapped in the relative world – I hope this blog has provided some support and has reinforced your convictions. I’ve been pleasantly surprised by how many investors share the absolute return mindset. In fact, our community has grown considerably over the past year.

For newer readers and to mark the blog’s one year anniversary, I put together a list of most popular posts. I hope you find them interesting and thanks again for reading!

Top Ten 18 Absolute Return Investing Posts:

  1. Parachute Pants
  2. Is This Investing?
  3. Buffett 1999 vs. Buffett 2017
  4. Loyalty, Prudence, and Care
  5. The Art of Looking Stupid
  6. What’s Important to You?
  7. The Wonder Years
  8. The Small Cap Police
  9. Category 5 Asset Inflation
  10. Look Away I’m Hideous
  11. The Passive Investor (PI) Ratio
  12. Monetizing Cats
  13. Special Dividends
  14. 95% Undateable
  15. I’ll Be Gone You’ll Be Gone Central Banking
  16. The Mullet Discount
  17. Mo’ Margins Mo’ Problems
  18. Investment Closers

Earnings season, or my busy season, is approaching. As such, I may not be posting as frequently over the next two to three weeks. I’m looking forward to gaining timely data points on the profit cycle and economy. I hope to share my observations and conclusions soon!

Patience – A Possible Win-Win

Investors long patience, or cash, are finally benefiting from asset inflation. As buoyant markets and low volatility allow the Federal Reserve to begin its normalization process, interest rates on cash and cash equivalents are on the rise. The three month T-Bill is yielding 1% while various savings accounts and cash equivalents are providing yields slightly over 1%. It’s not much, but for investors waiting for higher returns on their savings, patience is finally beginning to pay (side note: it may be a good time to check yields on cash to make sure you’re not getting shortchanged).

We’re in an interesting part of the market cycle for stocks and bonds. For most of this cycle, stocks and bonds have simultaneously enjoyed the wonders of 0% interest rates and central bank asset purchases. Things are changing. While I question the perception that the Federal Reserve has turned “hawkish” (short-term real rates remain negative), as long as financial conditions remain stable and equity prices inflated, the Fed will most likely continue raising rates. In effect, until something in the financial markets “breaks”, the Fed’s tightening path appears to be on a set course. Remember, they want to be transparent, predictable, and avoid sudden shifts in policy.

As stated in a recent post, the Fed’s plan to gradually raise rates reminds me of Greenspan’s attempt to exit from his extended period of easy money. During the second half of the Greenspan-Bernanke cycle (2002-2008), monetary policy was tightened consistently until the stock market crashed and the U.S. economy entered a severe recession. Is the Fed on a similar late-cycle path today? If so, I believe it’s possible patient investors will be rewarded regardless of whether stocks rise or fall.

Exactly when the current market cycle ends remains unclear, but in my opinion, the cozy relationship between short-term interest rates and equities is over. Going forward, higher stock prices will most likely lead to higher short-term rates. This changing relationship could be a win-win for patient investors. For instance, if stock prices remain inflated, I expect the Fed will continue to raise rates, giving patient investors a higher return on their cash. Alternatively, if higher rates cause the market cycle to end abruptly, patient investors would benefit from the avoidance of capital losses and lower stock prices.

While I continue to miss out on the all-too-easy gains in the stock market, I remain committed to my absolute return discipline and its requirement to remain patient during periods of overvaluation. Waiting isn’t easy, but with short-term interest rates trending upward, it’s gotten a little easier. As the later stages of the current market cycle unfolds, I believe patient investors will likely be rewarded with either higher returns on their liquidity or a more attractive opportunity set. After years of punishing 0% returns on cash and few genuine discounts to value in equities, I view both outcomes as refreshing and potentially very rewarding.

Please keep those rate increases coming!

Normalizing Earnings and Real Rates

I just completed a post discussing the pros and cons of the Shiller PE. After reading it I thought, “Geez, as much as I like discussing cyclically adjusted earnings, this is a boring read.” While some of you would like it, I think it would put too many readers to sleep. Therefore, I decided a more interesting way to discuss the topic was to publish an email exchange I had with a friend and fellow absolute return investor.

Discussion of the Shiller PE with fellow absolute return investor…

Me: Many articles and studies on stock market valuation state today’s market is the most expensive in history, except for the 2000 peak. After looking at the long-term Shiller PE chart this appears true. However, is it an apples to apples comparison? Specifically, during 1991-2000, central banks were not artificially suppressing real interest rates through asset purchases. What do you think about calculating a Shiller PE using a historical average real rate of around 300 bps, or similar to what we experienced in 1991-2000? In effect, making the periods more comparable.

Absolute Return Investor: To be clear, your point is if real interest rates were near average, borrowing costs would eat into EPS, hence a higher Shiller PE? If so, I’m in favor of any ratio that shows valuations more on an operating basis. I’m curious to know how you would calculate. Just take interest expense/debt for every company and add 200 bps?

Me: I was thinking 200-300 basis points and using the S&P 500’s aggregate debt to determine the higher interest expense. The yield on high grade corporate bonds during 1991-2000 (period used to calculate the 2000 Shiller PE) averaged approximately 7.6% versus 4.4% during 2008-2017 (period used in today’s Shiller PE), or a 300 basis point difference. The 10-year Treasury’s yield averaged approximately 6.5% in 1991-2000 versus 2.5% in 2008-2017, or a 400 basis point difference. Inflation during these periods was approximately 2.7% in 1991-2000 and 1.6% in 2008-2017. Therefore, in real terms, rates used in the Shiller PE calculation in 2000 were approximately 200 to 300 basis points higher versus 2017 (depending on if you use corporates or 10yr Treasury). For what it’s worth, real interest rates in 2000 were near long-term averages, while in 2017 they are significantly below (goes without saying!).

Absolute Return Investor: Before you go through the hassle of calculating, you might want to run P/EBIT or EV/EBIT to see the output. I know you’re not stripping out taxes but those stats are probably easy to find.

Me: Right. A Shiller EV/EBIT would be nice!

Absolute Return Investor: As you already know, you will have to preempt the argument that today’s low rates make a higher PE more acceptable.

Me: True. And I’m also aware real rates and profits will never normalize again! 🙂 But my point is since real rates are significantly below average and are artificially suppressed, the Shiller PE may do a good job of normalizing earnings over ten years, but not normalizing real interest rates (there’s nothing normal about 0% real yields!). It just seems this market is more expensive than 1999-2000 (especially broadly speaking), but based on the Shiller PE, it is not. However, based on my calculations, most of this discrepancy appears to be due to lower real interest rates.

Absolute Return Investor: It’s a good idea. We made some calculations on median PE. I occasionally see references to median PE being higher than the tech bubble, but wanted to run the numbers myself. Verified. But your idea takes it a step further. The only issue with doing EV is it gets messed up with all the financial companies in the index. And that if you increase rates for borrowing costs you should also inflate bank profitability. I’m not saying I agree, but I often omit financials from my analysis like these.

Me: Good points and makes sense. My calculation also wouldn’t include the impact higher real rates would have on operating profits of non-financials. Maybe P/S remains the best aggregate valuation metric, which weeds out a lot of this and of course verifies what we already know – stocks are expensive! I suppose debating valuations and what year stocks were most expensive doesn’t really matter at this point, especially given positioning (almost all cash). It’s more out of curiosity. I’m confident my opportunity set is the most expensive it’s ever been…just trying to get a better understanding why some valuation measures are more expensive than others.

Absolute Return Investor: Plus, the Shiller PE is going to lose its utility in a couple years when the last recession’s earnings fall off.  Have you thought about a modified Shiller PE where the trailing period fluctuates to include two full business cycles? Or at least one? An arbitrary 10 year time period doesn’t hold up in extreme environments.

Me: That’s a great idea – including one or two complete cycles instead of a fixed 10 year period. I remember in 2015-2016 thinking the Shiller PE was including two periods of earnings booms and only one earnings bust. It wasn’t balanced or complete cycles.

Absolute Return Investor: Exactly. So what’s your adjusted Shiller PE look like?

Me: After normalizing real rates and adding 200-300bps to the S&P 500’s interest expense, I’m getting a Shiller PE of 39-46x, which is quite a bit higher than today’s 30x and similar to the 1999-2000 bubble peak. The calculation is an approximation as I don’t have a database on aggregate S&P 500 debt and I’m still without a Bloomberg. I backed into the S&P 500’s debt by using published debt to equity and price to book ratios. Again, not that any of these aggregate valuation measurements influence decision making…just helps support what we already know, but I think it’s interesting nonetheless.

Absolute Return Investor: Ha! You’re like an analyst operating using smoke signals without a Bloomberg. Very impressive. I believe it.

Me: Life without Bloomberg…it’s like that Seinfeld episode when Jerry shares his “moves” with David Puddy but withholds them from George. When George discovers, he gets upset with Jerry and yells, “I’m out there rubbing two sticks together while you’re walking around with a Zippo!”

Thanks for your feedback. Very helpful!

Stimulant Bender

Coffee and I have a long history of booms and busts. I love its taste and smell, but unfortunately I’m highly sensitive to caffeine and need to be prudent on how much I consume (ironic that I currently work out of a coffee shop!). Despite my best efforts, there have been times when I’ve overindulged and paid the price. One of my most memorable coffee moments occurred while visiting Philadelphia for a day of client meetings and presentations.

I arrived at my hotel late the night before and was rushed to make my early morning meetings. To save time I decided to order room service. When breakfast arrived I immediately noticed it came with a large pot of coffee. It smelled incredible, but I was reluctant to pour a cup due to my sensitivity to caffeine. However, given I was tired, I thought I could handle and possibly benefit from a half cup.

Although I hadn’t had coffee in a long time, it went down smoothly – too smoothly. It was so good I couldn’t stop. A half cup turned into a full cup and a full cup turned into two cups. Before I knew it, I finished the entire pot, or five cups of coffee. Now that was a delicious breakfast! And even better, I apparently overcame my sensitivity to caffeine. Feeling full and refreshed, I looked at the clock and rushed to my presentation.

Fortunately my first meeting was right across the street from the hotel. I arrived just in time and sat in a boardroom with a group of consultants. As we enjoyed some small talk, I began to sense something was wrong. I started to feel warm and began to sweat. What was happening? The office was cold so it wasn’t the temperature. Was I nervous? I didn’t think so as it was a friendly crowd and it’s a presentation I’d given hundreds of times. And then it hit me – oh no, I may have drank too much coffee! Just as I made this realization a tidal wave of caffeine crashed over me and my presentation began.

After being introduced, I was asked to tell everyone about my absolute return strategy. “Tell you about my strategy?” I thought, “I don’t even know my name!” My heart was racing and I was having trouble concentrating. I wanted to, but was unable to say, “Excuse me, but I just drank a pot of coffee and I’m seriously considering running through that wall behind you.” Finally some words came out and I gave an hour presentation in 15 minutes. I concluded by asking, or yelling, “Questions, questions, questions?! Thank you!!!”

My sales rep rushed me out of the meeting like a shot president. Once safely in the elevator she asked, “What was that?” I replied, “That was a pot of Philadelphia’s finest coffee.” Needless to say, from that day forward, I was back on the coffee wagon and sentenced to a life of green tea.

Although I didn’t need to drink an entire pot of coffee make this point, overdosing on caffeine was a good reminder that there are limits and when those limits are exceeded there are consequences. Because I didn’t feel the effects after my first cup, I thought it was safe to drink another cup. And after my second cup I still felt okay, so I thought it was safe to have a third. And this line of thinking continued until the entire pot of coffee was gone. While the consequences were delayed, my sensitivity to caffeine did not miraculously disappear and this time would not be different.

Speaking of overdosing on stimulants, several Federal Reserve members spoke publicly this week. For the most part, central bankers continue to go about their business as if they didn’t serve investors five cups of monetary coffee. Fed members recently increased their hawkish tone, raised rates 25 bps, and continue to discuss plans to reduce the Fed’s balance sheet. In their eyes, and in the eyes of many market participants, central bankers are firmly in control of the financial markets and their exit strategy.

On Monday, San Francisco Fed President John Williams stated the U.S. economy is “about as close to” the Federal Reserve’s goal of maximum employment and 2% inflation “as it’s ever been.” This made me wonder, if the economy is as close to the Fed’s goal as it’s ever been, why does monetary policy remain so close to where it’s never been?

In his speech, Mr. Williams provided clues as to why monetary policy remains so accomodative. Specifically, he acknowledged concerns that the normalization process could cause “market turbulence”. He reassured investors by saying, “The last thing we want to do is fuel unnecessary or avoidable volatility or disruption—whether we’re talking about domestic markets or international markets.”

Based on recent comments from Fed members, it appears the Federal Reserve’s main tool to combat potential “volatility and disruption” in financial markets, is to normalize policy gradually and be transparent. Mr. Williams stated, “The more public understanding, the less chance that said actions will fuel unnecessary volatility in the markets.”

I can’t help but be reminded of 2004-2006 when Greenspan took a similar gradual and transparent path (I call it “pretty please” monetary policy). After raising rates in 2004, Greenspan communicated to the markets that increases in interest rates “are very likely to be measured over the quarters ahead.” Gradual and transparent is what Greenspan wanted and it’s exactly what he delivered. The Greenspan Fed raised rates at a measured pace for 14 consecutive quarters before passing the monetary baton to Bernanke in 2006.

Initially Greenspan’s transparent and measured approach was successful in promoting further asset inflation and credit growth, but in the end, it was unsuccessful in painlessly deflating the equity, mortgage, and housing bubbles. Eventually years of easy money and credit caught up with the Fed as its measured and transparent approach failed, while “unnecessary volatility” prevailed – overwhelming investors and policy makers.

Similar to 2004-2006, investors currently do not appear threatened by the Fed’s measured and transparent (predictable) normalization process. In fact, based on asset prices and valuations, investors appear to believe the normalization process is “transitory” and more, not less, stimulative policy is on the way.  And they may be right. Who doesn’t believe a pot of QE4 will be brewed during the next market correction?

As the Federal Reserve attempts to exit from years of record low interest rates and previously unimaginable asset purchases, I’m reminded of my experience with overdosing on caffeine. I have unfortunate news for the Fed. There is not a safe exit from a stimulant binge – even if you stop, the effects are already in the system. In the case of the Fed, their relentless doses of monetary caffeine have already significantly altered interest rates, asset prices, capital allocation decisions, and balance sheets. The only uncertainty, in my opinion, is how many more cups of monetary stimulus can be served before investors realize something is wrong, get jittery, and cause the central banks to lose control.

As I’ve been recently diagnosed with chronic central bank fatigue syndrome (CBFS), I’ll be back to writing about individual businesses next week. We’ll have more substantive news to discuss and analyze soon as earnings season is approaching — I’m really looking forward to it. Have a great weekend!

Energy Checklist

I’m working on several beaten down energy stocks this week and won’t have time to post. That said, I thought I’d put together a quick checklist of some of the things I’m looking for in potential energy investments.

  1. Companies that took advantage of the recent rally (generosity of dip buyers) and issued equity above net asset values. In several instances, energy stocks are trading well below the prices of 2016-2017 equity offerings. If an energy business was able to improve its balance sheet or buy distressed assets with equity proceeds, its net asset valuation may deserve a boost (due to lower financial risk and issuing equity above intrinsic value).
  2. Companies that extended their debt maturities/maturity wall. I continue to be amazed by the level of generosity in the credit market, especially given how close many energy companies came to bankruptcy. Specifically, I’m looking for companies that successfully extended maturities to 2022-2025 and with untapped credit lines. Several debt and equity offerings were used to pay down credit lines, which allowed many banks to dodge the energy credit bust bullet. I’ll most likely avoid companies that were unable to refinance debt over the past 1-2 years on favorable terms – it’s a red flag.
  3. Companies that hedged a significant portion of 2017 and 2018 production at favorable prices. During sector troughs it’s about surviving, not thriving. Cash flow insurance helps.
  4. Companies with net debt to discretionary cash flow of 3x or less (using current commodity prices).
  5. Avoid energy stocks that could double or go bankrupt within a year. I call this coin flip investing. Energy companies that I consider coin flips are often reliant on near-term commodity prices for survival. I only want to consider energy companies that can survive an extended period of depressed commodity prices. On a side note, while coin flip investments are not appropriate for long-only absolute return investors, they may be an interesting speculation for certain option strategies (simultaneously buying puts and calls).
  6. Companies that can survive by drilling within cash flow. In other words, companies that are not reliant on fickle bankers or the bond market and can pay their bills with operating cash flow.
  7. Avoid valuing energy companies on cash flow. In my opinion, this creates too high of a valuation during booms and too low of a valuation during busts – it encourages buying high and “freezing” when prices are attractive. I prefer a net asset valuation based on replacement costs as I believe it’s a less volatile and more accurate valuation methodology.
  8. Avoid finding comfort in large discounts to net asset values without sufficient liquidity. It doesn’t matter if the business is selling at a significant discount to net assets if the business doesn’t have the necessary liquidity to survive. Tidewater’s (TDW) recent announcement to enter Chapter 11 is a good example. As of 3/31/17 Tidewater’s book value was $35/share and its stock is currently trading at 80 cents. I wrote about energy stocks and Tidewater in the following post: You Got Your Chocolate in My Peanut Butter
  9. Avoid extrapolating. Energy stocks are often either significantly undervalued or overvalued – rarely do they trade near fair value for long. In my opinion, these are not buy and hold investments and an area where active management can add considerable value. Take risk when getting paid during the busts and avoid the temptations of holding throughout the booms (For what it’s worth, I’ve found selling in the booms is often harder than buying during the busts – greed can be so powerful!). A rule of thumb I’ve often used is be cautious when commodity prices are 2x the costs of replacing reserves and production (additional supply and the next bust is usually on the way).
  10. The bottom in energy prices and energy stocks is almost impossible to predict. Be prepared to suffer large unrealized losses as you wait for the cycle to run its course. Low prices and tightening credit should ultimately reduce supply, leaving survivors with strong balance sheets in a favorable position. Lastly, if you miss the bottom, do not worry, the energy industry is home of second chances! Given the energy industry’s obsession with production growth and the financial industry’s obsession with funding that growth, higher supply and the next bust is usually right around the corner.

In conclusion, I’m currently looking for energy companies trading at a discount to my net asset valuation with strong enough balance sheets to make it through the cycle. Given most energy company balance sheets continue to have too much debt, I plan to be very selective and do not expect many energy companies will pass my checklist. That said, I’m hopeful the current mini-bust gathers momentum and provides absolute return investors with an improved opportunity set. Although sector bear markets are often very narrow, they can also be very rewarding. Happy hunting!

Mo’ Margins Mo’ Problems

Investors have a tendency to gravitate towards leading brands and high margins. Such traits are often an indication of a high-quality business and meaningful intangible assets. While brands can be very valuable, they are not free. Brands require considerable investment and ongoing maintenance. Furthermore, similar to many things in business, there are cycles, trends, and risks associated with even the best brands. For example, many consumer brands have recently faced challenges as consumer perceptions, behaviors, and spending patterns change – few are immune. In fact, one of the strongest consumer brands I follow, Ralph Lauren (RL), recently reported a -16% decline in quarterly sales as it responds to structural shifts in retail.

The value of a brand fluctuates and is subjective. If a company places too high of a value on its brand, it may price its products or services too aggressively, risking sales and distribution relationships. The price difference between premium brands and lower quality brands or private label is also known as the price gap. The price gap is a very sensitive issue and risk for businesses with leading brands. If the price gap is too low, the company risks receiving an inadequate return on assets (the brand). If the price gap is too high, the company risks losing volume and customer loyalty. 

For example, my favorite ice cream is Publix GreenWise, a private label brand. I tried GreenWise after Breyers increased the price of their ice cream via smaller packaging (half gallon to 1 ½ quarts). In effect, the price gap between Breyers and Publix’s private label brand became too large and noticeable, so I gave the GreenWise brand a try. To my surprise the alternative was very good, and in my opinion, even superior (in taste and organic ingredients) to the more expensive leading brand.

Another risk consumer brands face is increased competition and consolidation within the retail industry. Bloomberg recently wrote an article discussing the growing threat of European grocers entering the U.S. market (link). As retailers and grocers are being squeezed by aggressive competition, their suppliers, including leading consumer brands, should also expect to be squeezed. As such, it may become increasingly difficult for leading brands to gain market share, raise prices, and maintain above average profit margins.

To illustrate, imagine you’re a grocer with low single-digit margins and European grocers are entering your markets. Keep in mind the strategy of your new and aggressive competitor is to take market share by undercutting you on price. Now imagine a branded company with 15-20% operating margins, a healthy dividend, and large buyback program coming to you and requesting a price increase necessary to maintain their margins. It’s similar to a wealthy 1%’er with a portfolio of FANGs asking the 99% for financial aid!

The J. M. Smucker (SJM) Company reported earnings last week and discussed many of these competitive issues. I consider J. M. Smucker to be a good business with many leading brands. That said, they’re currently operating in a challenging environment, with organic growth slowing to a crawl. Specifically, sales are expected to grow 1% in 2018, with EPS increasing 2%-4%.

On their quarterly conference call, management was asked if the pricing environment has become more challenging. Management noted they have heard about “additional pressure” but they have been successful in pushing through price increases. That said, they acknowledged it is taking a little longer to get price adjustments through with a couple larger customers.

Management was also asked about growing promotions in private label. They responded their customers view private label “as one of the arrows in their quiver to get them price points to compete with those channels [discount grocers and retailers]. And so we’ve seen aggressive activity in all the commodity-based things, in coffee, and across a number of different categories, right? So are we concerned about that? Yes.” Management went on to note they are fortunate to be the leading brand in their core categories.

On the pricing gap between their brands and private label management stated, “We understand what price points we need to hit on that product to maintain the right pricing gaps. In the vegetable oil business, we understand — we have great detail on the gap we need to have with private label. We can be above private label in all of those cases, but we can’t let those gaps get too large.”

As competition and consolidation in retail increases, leading brands will not be immune to volume and pricing pressures. Last week I discussed Casey’s General Stores (CASY) and how their customers are moving away from cigarette cartons to packs. Management also mentioned the shift from brands to generics. To slow this trend, leading brands will need to monitor their pricing gaps closely. If they maintain or increase the pricing gap, lower sales and volumes should be expected (Ralph Lauren is a good example). If the pricing gap is reduced to maintain volume and market share, margins could suffer.

While investors are attracted to leading brands and attractive profit margins, in the current consumer environment, I believe elevated margins should be analyzed carefully for sustainability and trend. High margins have always attracted competition; however, given current pressures on consumers and retailers, it may be purchasing managers that becomes the bigger threat. Given the difficulty many brands are having growing volume and passing on price increases, it appears this process may be well under way.