Money For the People

While watching Bloomberg TV tonight I noticed the following headline, “Protesters Tell Bank of England Bond-Buying Plan Isn’t Working”. The article says 40 protesters chanted, “Create money for people, not financial markets.” It was only a matter of time before the general population figured out it’s better if the money printing was distributed directly to them instead of benefiting only those with exposure to financial assets.

I suspect the protests and pressure will grow until politicians eventually agree. QE for the people will most likely be launched during the next recession. An easy political test-run in the U.S. would be a stimulus package that forgives student debt ($1.3 trillion or so) and pays for it with QE or helicopter drops (essentially the same thing as QE but without the middleman). It would be a popular program and tough to argue against politically, but easy to argue against with any knowledge of monetary history. Infrastructure spending would also be a front-runner. Whatever the QE cannon is focused on, I’m not sure I’d want to own no to low yielding bonds once QE for the people is implemented, or even discussed.

Penalties Offset – Replay Third Down

Several consumer companies reported results over the past two weeks. After reviewing Q2 earnings reports and conference calls, I concluded consumer businesses were experiencing a slight slowdown. Since then, I’ve been paying close attention to consumer businesses and remain on the lookout for changing trends. Over the past few days, I’ve reviewed several consumer companies’ quarterly reports and conference calls and provided brief summaries below.

Ralph Lauren (RL) reported weak results, but its stock moved higher as it won the earnings estimate game (weak results were expected/restructuring). Total sales declined -4%. Wholesale segment revenues declined -5% mainly due to challenging traffic trends at U.S. department stores. Retail segment sales declined -3% and same store comps declined -7%. Management blamed lower traffic and a challenging economic environment. Interestingly, online sales declined -6%. Management noted it is “harmonizing” its pricing. The company is expecting revenue to decline low double digits in fiscal 2017 due to “a proactive pullback in inventory receipts, store closures, pricing harmonization and other quality of sales initiatives combined with the weak retail traffic and a highly promotional environment in the US.”

TJX Companies (TJX) reported solid results, but apparently lost at the future earnings estimate game, as its third quarter outlook was disappointing. Same-store sales were relatively strong in my opinion, up 4%. Management noted most of the comp increase was due to traffic, which is different than most consumer companies I’ve reviewed (traffic and transaction growth was weak last quarter, even for companies reporting positive comps). As operating results suggest, management believes they are gaining significant market share. All things considered, it looked like a good quarter to me. But what do I know — its stock actually declined on one of the better retail reports I’ve seen recently. At 22x 2017E earnings, I’m assuming part of the negative response may have been valuation based. Also while 4% comps are well above average for retailers, comps are slightly below last year’s average of 5%.

Dicks Sporting Goods (DKS) reported satisfactory results that the market seemed to like. While same store comps were up a moderate 2.8%, investors were relieved The Sports Authority liquidation appeared to have little impact. The exact impact is unknowable and we’ll have a much cleaner comp next quarter. On the conference call management noted sales actually benefited from the liquidations at the end of the quarter. Finally, on traffic, management said, “DICK’S Sporting Goods omnichannel same-store sales increased 3%, driven by a 1.3% increase in ticket and a 1.7% increase in traffic.“ Given the uncertainty regarding how competitor inventory liquidations impacted results, I don’t believe it’s a good idea to use Dicks’ operating results as a broader macroeconomic data point at this time.

Target Corp. (TGT) reported poor results and lost at the earnings game. I have not reviewed their conference call yet, but same store comps declined -1.1%. Same store comp expectations for the second half (where’s the second half recovery?) are 0% to down -2%. Once I read their conference call I’ll know more, but it appears to be simply general weakness.

The Home Depot (HD) reported solid results with 4.7% growth in same-store sales. Interestingly, a large portion of this increase was due to the average ticket growing 2.5% while transactions were up 2.2%. This is similar to what I’m seeing with most consumer companies reporting positive comps – a meaningful portion is coming from mix and price. According to management, “…big-ticket sales in the second quarter, transactions for tickets over $900, representing approximately 20% of our US sales, were up 8.1%. The drivers behind the increase in big-ticket purchases were HVAC, appliances and roofing.” In my opinion, relative to other retailers, Home Depot is benefiting more from asset inflation. Considering I believe asset inflation is unsustainable, I would argue Home Depot’s sales trends are at greater risk to The Great Normalization (when asset prices revert to fair value). Nonetheless, its current business is performing well and it was a solid quarter.

Lowe’s Cos. (LOW) results were slower than expected and it also lost at the earnings estimate game. Comparable sales were up 2% while U.S. based stores were up 1.9%. Average ticket was up 1.7% and transactions were only up 0.3%. Ticket size over $500 was up 2.9%, which is well below Home Depot’s high ticket size transaction growth. I would have expected Lowe’s to benefit more from asset inflation. Interestingly, in their quarterly slide presentation they note appliances performed only “average”. I haven’t read their conference call yet, but based on the press release and slides, it looks like a sluggish quarter given the macro benefits they should be experiencing.

In conclusion, after reviewing these quarterly reports and conference calls, I believe it’s difficult to draw a conclusion as it relates to changing consumer spending trends. Overall general merchandise appears weak, while consumer companies positioned closer to asset inflation, such as Home Depot, continue to perform better. However, when viewing business trends based on transaction growth, even the companies performing better are not reporting particularly strong results. Gains based on price and mix are beneficial, but I’d argue are more dependent on the sustainability of asset inflation and the consumer’s willingness and ability to pay more. Overall, I’d call these reports mixed and inconclusive – penalties offset, replay third down! As we get more data I’ll put it all together and try to determine if Q2 was a blip or something we should be more concerned about. Or more accurately, what investors in stocks should be concerned about. I remain out of equities entirely.

Is This Investing?

I had a very interesting conversation with an experienced value investor last week. We talked about a variety of topics, but one question he asked me really stood out and I continue to think about today. Has the investment landscape changed permanently? It certainly feels that way. However, we need to be careful in declaring so, as the history of financial markets is littered with “this time is different” corpses.

This is an important topic for me and for thousands in the investment management industry. If things have permanently changed, there is little need for fundamental research and experienced investment judgement. Instead of continuing to follow my 300-name possible buy list and organizing my thoughts on this blog, maybe I should be in trade school learning how to wire a house, or even better, make an irresistible pizza!

I touched on this subject in an earlier post, “If You Think Nobody Cares About You, Try Missing a Couple Payments.”  In the post I wrote, “I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along?”

Is this investing? It’s a very relevant question in today’s financial world. Is buying a bond with a negative yield investing? By definition it is not. Investing is defined as committing capital with the expectation of receiving an income or gain. Assuming a negative yielding bond is held to maturity there is no expectation of receiving income, only losses. It is not investing (I’m sure you didn’t need me to tell you that!).

I have a different definition of investing. To me investing is much broader than simply committing capital to make a profit. It’s a process. A lot goes on from the time I discover an investment idea, perform due diligence, and make the purchase and eventual sale. For me, and for thousands of fundamental-based investors, it’s a long and thorough bottom-up process with a healthy mixture of critical thinking and subjectivity. Over this long process, I build an understanding of a business and develop an opinion of its intrinsic value. I then compare my opinion of the business’s worth to its market price. Seems simple enough, right?

I suppose it is. And I suppose the investment process as it relates to determining an asset’s intrinsic value hasn’t changed, but what about the purchase and sale portion of the process? The purchase and sale portion of my investment process often relies on changing fundamentals to create opportunity (purchase) and drive the investment’s price to my calculated valuation (sale).

Let’s assume market prices are not allowed to fluctuate based on fundamentals. Instead, policy makers interfere and asset prices are set to levels they deem appropriate, not by market participants. In such an environment, market participants are price takers, not price makers, and fundamentals become less relevant. Is this still investing? Not as I define it.

In my opinion, the prices investors are now taking do not accurately reflect the true risks underlying a variety of investments, ranging from “risk-free” government bonds to small cap stocks. Risks, along with other fundamental variables, are becoming less of a factor in determining asset prices.

As fundamentals decline in importance, the value investors place on the perceived safety of central bank price fixing, along with their reassurances that financial instability will not be tolerated, is growing. This new and intrusive investment variable, the central bank backstop, is difficult to value as the exact premium for its perceived “safety” is unknowable. Nonetheless, I believe it’s having a significant impact on how investors view and justify inflated asset prices.

This time is not different, but the cycle is…

I believe the pricing mechanism in financial markets is broken and asset prices are currently artificially inflated. Simply put, the prices of stocks and bonds would not be where they are today without central bank intervention. I don’t see how this is debatable. Whether asset prices are directly or indirectly set by central banks could be up for debate, but in my opinion, financial markets are not functioning properly and are not moving freely.

As I’ve attempted to illustrate in previous posts, asset prices are not properly responding to fundamentals, which is further evidence markets are malfunctioning. Despite this, I’m optimistic free markets will return with fundamentals and valuations eventually retaking the throne of what’s most important.

When free markets return and valuations normalize, I believe asset prices and opportunities will improve considerably. It is why I continue to follow the companies on my possible buy list and remain engaged with the financial markets – I’m waiting for what I call “The Great Normalization”. Although I believe free markets will return, I do not know when the normalization process begins, or how long this period of artificial asset prices lasts.

It’s understandable why so many believe the investment environment has changed permanently. Central banks appear to be in complete control as every little hiccup in the market is met with decisive verbal or real countermeasures. It really does feel different this time. But don’t all asset bubbles feel different? The often cited Irving Fisher quote from 1929, “Stock prices have reached what looks like a permanently high plateau” is often ridiculed, but how different is this quote from the actions most investors are taking today?

Since investors are willing to pay current prices for stocks and bonds, they must believe something has permanently changed. Investors can’t believe stocks and bonds are good investments while also believing interest rates, profits, and valuations are going to normalize. When normalization occurs, investors will most likely incur significant losses. Therefore, buying assets at current prices implies investors believe rates will not normalize and valuations will remain well above historical norms. In other words, today’s investors are making the same assumption as Irving Fisher in 1929, that this time is different (ironically in 1929 the cycle was eight years old – sounds familiar!).

While I don’t believe things have permanently changed, I am aware that this cycle is different than past cycles – there has never been this type of coordinated monetary policy response. The last cycle (2003-2008) was just a good old-fashioned credit bubble. There was a limit to how far it could grow before it burst. For example, a bank’s balance sheet can go from 10x leverage to 20x leverage and maybe even 30x leverage, but its leverage can’t expand indefinitely. A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.

Central banks’ unlimited purchasing power is reassuring to many, but for others (like myself) it’s extremely unsettling. Instead of raising taxes or cutting spending, why not print money to pay for the next need of the moment? It starts slowly and picks up speed as politicians and policy makers figure out an endless supply of “money” and crowd appeasement is literally a keystroke away. How will this power not be abused? And how has it not already been abused? How much debt has already been monetized globally to fund government deficits and spending? I believe it’s around $12 trillion and growing considering the ECB and BOJ continue to monetize stocks and bonds.

Monetary policy uncertainty and risk premiums

While the consequences of eight years of emergency monetary policies as it relates to asset inflation is clear, there are other consequences that are less obvious. One is the large number of investors that were once obsessed with bottom-up fundamental analysis, are now experts in central bank policy (this was another interesting topic of conversation I had with the experienced value investor). How can we all be experts on something that has never happened before? While we should acknowledge the influence central banks are having on financial markets, how can any of us know exactly how things unfold and what the ultimate consequences of these extreme monetary policies will be?

I argue we don’t know and we can’t know. And this includes the central bankers themselves! As such, shouldn’t the biggest uncertainty facing investors today (global monetary policy) be a reason to require a higher return on assets, not less. Considering we have never experienced these sort of monetary experiments before, along with the fact that whenever it has been tried by an individual country it’s ended badly, why are investors paying record prices for stocks and accepting record low yields on bonds? In effect, the investment environment is more uncertain today (risk higher) due to global monetary policies, not less. Can anyone name one instance when monetizing debt was successfully implemented and exited from? As a newly unemployed person, I’m open-minded to the wonders of money printing. If monetizing debt and helicopter drops work, let’s get on with it so we can all retire!

The last credit and economic cycle was very different than today’s central bank driven cycle. An investor could locate the eventual problems by following the debt (the mortgage debt trail led to the banking system). This time is different as a lot of the government debt that has been created has been monetized and is on central banks balance sheets. Central bank policies have depressed risk free rates and inflated asset prices. Instead of following the debt this cycle, I believe it’s more important to follow the asset inflation.

In my opinion, areas of accumulated asset inflation is where the risks of this cycle are centered. Instead of the banking sector catching most of the heat when this cycle ends, I believe it will be fully invested mutual funds, ETFs, pension funds, hedge funds, private equity funds, and any other financial vehicle that is underpricing risk and holding a pile of inflated assets.

When investors determine central bank policies are ineffective or counterproductive, the unlimited central banker bid will disappear. When that occurs, how will set prices respond when they become unset? I’ve managed small cap stocks for 20 years and I know what it’s like when the bid goes away. It’s not pretty. People panic. Large investors who need to get out drive prices down until they find a sizable bid. Before that bid can be found, there is a large air pocket. How all of these funds locked and loaded in risk assets will be able to find buyers during the next market liquidation is beyond me, especially given the sharp increase in ETFs and index fund investing.

In the meantime, investors aren’t very concerned. In fact, many investors are pressing their bets.  According to a recent Bloomberg article, “Professional speculators are making record bets in volatility markets that U.S. stocks will keep rallying.” The volatility index VIX traded near 11 last week. Another Bloomberg article quoted a trader as saying the VIX dropping below 11 by end of month is “very possible” in a market that central banks built “with lower rates and asset buying and money.” The investor also said, “It’s a “Field of Dreams” market because “if you build it, they will come”; “central banks built it” and “investors have come”.

Is this investing?

 

Estimates vs. Reality

On Friday I received a Bloomberg article from a friend stating earnings for the S&P 500 are now expected to decline 0.1% in 2016. For those of us following individual businesses, this shouldn’t be a surprise. As I’ve been documenting with specific examples, companies are beating earnings estimates, but actual operating results are sluggish, on average.

Particularly interesting, the article stated analysts in December were expecting 2016 earnings to increase +7.1%. Up high single-digits and now negative is a large decline in expectations. Given the sharp reversal in earnings estimates, why didn’t most companies report earnings disappointments this year? They should have, but keep in mind how the earnings game works. As the year unfolds, companies gradually communicate lower earnings guidance to analysts. To properly play this game, companies must drop the earnings bar low enough before quarterly earnings are announced.

It appears the game was played “properly” by both the companies and the analysts last quarter, as over 70% of companies beat earnings estimates. Investors played their part as well and ignored the gradual decline in earnings estimates throughout the year. Everyone is rewarded for playing the earnings estimate game. Management sees their stock increase, stock options go up in value, and they get plenty of “great quarter guys” compliments on conference calls. Analysts also look smart as they properly lowered their estimates and were reasonably close to actual results (provides job stability and company access). Last, but not least, investors are rewarded as stocks typically appreciate when earnings beat estimates.

Despite the decline in annual earnings expectations and poor actual results, investors have been rewarded for playing the earnings estimate game so far this year. Stocks on average are up approximately 7% YTD even though S&P 500 earnings estimates have declined from +7% growth at the beginning of the year to -0.1% currently.

Instead of playing the earnings estimate game, I believe absolute return investors are better served by focusing on actual earnings, as actual results are used in determining business valuations. When valuing a business based on discounting free cash flow, when have you ever asked yourself if they beat estimates last quarter? Comparing actual results versus estimates is irrelevant in determining long-term cash flow forecasts and judging business performance.

So how are businesses performing? It depends. Based on estimates it’s good, based on actual results it is not. According to Bloomberg, “As 2Q earnings season draws to an end, 72% of S&P 500 companies reported forecast-beating profits; however in absolute terms, profits are down 3% year over year.” I really like that, “in absolute terms.” Shouldn’t that be what counts – what’s really happening?

Lastly, the second half hockey stick recovery appears to be at risk (see July 21 post). Bloomberg quotes a JPMorgan equity strategist, “We continue to believe that consensus estimates of a rebound in 2H earnings, to new highs particularly in the U.S., are too optimistic.” This won’t be the first time the second half recovery doesn’t make its appearance. The realization that the second half recovery isn’t coming usually happens around the time of the Charlie Brown Halloween special, when Linus and Sally anxiously wait in the pumpkin patch for The Great Pumpkin…that never comes. How appropriate.

Bread and Plastics

As discussed in a previous post, one of the most noticeable trends this cycle has been the significant growth in companies taking on debt to acquire, buy back stock, and pay dividends. It seems almost every company I’ve worked on recently has the same capital allocation strategy. I believe this is the main reason corporate debt has increased, especially due to the trend in acquisitions. As debt and acquisitions increase, the number of public companies is decreasing. The USA Today recently reported that the number of public companies is 3,678, down from the high in 1998 of 7,562.

On average, I do not believe the “acquire with debt” strategy has been successful from an operating perspective. Whether that’s because of the low growth environment, the price companies are paying, or integration issues, is inconclusive. What is conclusive is a lot of companies that are reporting poor results this quarter have much weaker balance sheets than a few years ago. It appears they’re all calling plays from the same capital allocation playbook. Flowers Foods (FLO) and A. Schulman (SHLM) were two of the most recent companies I follow that announced poor results and have acquired with debt.

Flowers Foods reported weak operating results yesterday. Flowers is a market leading bakery (mainly bread). Sales increased 5.2%, but 5.6% of this was from acquisitions. Its core business, fresh packaged breads, reported its unit sales declined -1.5%. Management blamed poor results on soft consumer demand in the baking category along with an increase in promotions. In addition to disappointing operating results, Flowers’ balance sheet has weakened this cycle with net debt of $1 billion vs. a practically debt free balance sheet in 2007 ($10 million). Most of its debt came from acquisitions in 2013 and 2015 along with cash outlays to support an above average dividend.

Flowers is another example (in addition to the Hanesbrands example posted Wednesday) of a consumer staple company that is perceived to be risk-free but is not. As a TV show like MythBusters would confirm, consumer staple companies are not immune to economic trends. As I stated in a previous post, I don’t believe the consumer is in a recession, but in my opinion there has been a noticeable deceleration in consumer demand this quarter. Whether this trend accelerates or stabilizes will be something I plan to watch very closely. On a side note, several consumer company-specific data points are conflicting with the recent employment reports. I’m not so sure the consumer is as healthy as recent employment data suggests. As usual, I’ll stick with what the companies are reporting, not the government.

A. Schulman is the other company that reported weak results yesterday. A. Schulman is a provider of high-performance plastic compounds, composites, powders and resins. Its products are sold to a wide variety of industries. Its plastics and compounds are used in food packaging, security/anti-theft packaging, interiors, exteriors and under the hood applications, automotive electrical and electronic parts, polyethylene pipe production and insulation, window frames, green house frames & films, mulch and silage film, irrigation systems and tanks, building & construction, power tools, small appliances, stadium seats, helmets, coolers, synthetic grass system for hockey, tennis, and golf, toothbrushes, razors, shampoo bottles, diapers & adult incontinence. Sorry for the long list, but I wanted to highlight the fact that they sell into many areas of the economy.

Considering the number of industries A. Schulman sells into, I’m always curious what they have to say and listen to their conference calls every quarter. Unfortunately, there was not a call today, only a press release preannouncing poor operating results. The company lowered full-year guidance from $2.40-$2.45 to $1.90-$1.95 due to “deteriorating market conditions facing the industry in the Company’s largest regions in the U.S. and Europe.”

Management also made some macro observations I thought were interesting, “At the beginning of the quarter, our key end-markets in the U.S. and Europe did not present notable headwinds; however, as the quarter progressed we saw double-digit volume contraction. This softness has continued into August. Our top line was particularly impacted in our Masterbatch Solutions, Engineered Plastics and Engineered Composites product families driven by softness in multiple markets.”

Similar to Flower Foods and others, A. Schulman has taken on considerable debt this cycle to acquire and pay dividends. A. Shulman currently has $939 million in net debt as of 5/31/16 vs. an almost debt free balance sheet as of its fiscal year ending August 31, 2008 ($15 million).

In addition to accumulating debt this cycle, what else do these very different companies have in common? They’re both in very mature industries, attempting to grow through acquisitions, and their operating results are struggling this quarter. Bread and plastics aren’t the only businesses generating uninspiring results. While 70%+ of companies beat their spoon-fed earnings estimates again this quarter, actual results have not been nearly as strong as all of the “beat earnings” headlines suggest. In my opinion, operating results of businesses are telling us something is wrong in the economy – fundamentals are not strong. Meanwhile stocks continue their march to new record highs. I haven’t seen this amount of disconnect between fundamentals and price since 2007. Is anyone paying attention?

Insiders appear to be paying attention and they also seem to agree with me. As Bloomberg reported today (thanks to a reader for forwarding this to me), “With equities setting records, insider purchases are dwindling, with two buying for every nine that sold. At 0.23, the buy/sell ratio is about one-third of what it was in February and last August, and compares with an average of 0.69 over almost three decades.”

It’s people who are looking at the fundamentals of their business every day and seeing a picture that’s deteriorating,” said James Abate, who helps oversee $1 billion as chief investment officer at Centre Funds in New York.

I agree with Mr. Abate as I’m seeing the same picture in earnings reports and conference calls. The article also mentions earnings are expected to decline again in Q3, which would be the sixth consecutive quarter of earnings declines. This is simply an amazing investment environment we find ourselves in. Think about it. We could have six consecutive quarters of earnings declines, while stocks march to record highs and volatility is near record lows. The amount of complacency is something I’ve never seen and hopefully will never see again.

Although I’m aware my beliefs and positioning could be proven wrong, I’m sincerely concerned for other peoples’ savings and the implications the end of this cycle will have on a lot of unsuspecting and innocent people. Many investors who can’t start over and can’t afford large losses have been sold the T.I.N.A. bill of goods or have been convinced central banks will bail them out if the unthinkable (asset prices decline) occurs.

It’s tough being all cash. I want opportunity and financial market normalcy to return, but I’m aware this will require significant declines in asset prices – a lot of people will be hurt in the process. It’s unfortunate we’re in this position, but after countless interventions and assurances by policy makers and asset inflation proponents, here we are. I wish we weren’t.

 

 

Absolute Return Investor — Frank Martin

I’m often asked if there are other absolute return managers out there. There’s not many, that’s for sure – we’re dropping like flies! However, there are several still managing money the right way (I’m very biased!) and fighting the good fight. David Snowball from Mutual Fund Observer has written about several (he provides a good list in his May or June 2016 monthly publication).

Another absolute return manager I have a great deal of respect for is Frank Martin. He’s been at it a long time and has twice the experience as I do. I’ve read his annual reports in the past and his last book. If you haven’t read his annual reports I strongly recommend them. They can be found on Martin Capital Management, LLC’s website under “Publications”. In any event, below are a few paragraphs from Frank’s last quarterly letter. He explains aspects of absolute return investing so well I wanted to share. Enjoy!

Frank Martin on groupthink [my bold]…

Our policymakers are flying blind and if we—as risk-averse, absolute-return investors—fall into lockstep with our peers we are certain to join them as all-too-witting victims in a loser’s game. Harking back to career risk, the irony is that we can only win individually if in the long run our clients win collectively. Otherwise, when months become years, the outcome will be mutually assured misery. The quarter-to-quarter performance battle is not so easy. Winning the war rests in large measure with the patience and understanding of the clients we serve. In pursuit of our mutual gain, we must leave the false security of the herd and reject Keynes’ admonition, “It is better to fail conventionally than to succeed unconventionally.” In the simplest of truisms, if we think and act like everyone else, we cannot expect to be above average. We have no choice but to take the lonely road less traveled.

…and valuations, positioning, and patience.

No matter what reputable valuation metric one chooses—whether Tobin’s Q, the ratio of the total market of U.S. equities to corporate net worth, or Bob Shiller’s CAPE (cyclically adjusted price-earnings ratio), the message is the same. In the aggregate, the S&P 500 is very expensive and, as we will willingly acknowledge, can remain so for an uncomfortably long time.

But we can also unequivocally state that following every other secular bull market since 1900 when the market was as expensive as today’s, real compounded annual returns, including dividends, sank to 3% or less by the time the subsequent market trough was reached. Although rarely mentioned by other longview investors, it is the psychological trauma that is the undoing of most investors during agonizingly long bear markets—for which the six months between September 15, 2008, and March 19, 2009, hardly qualify—when prices seem inexorably to recede with no end in sight, in a pattern of one step forward, two steps back. Hope soon fades to despair, and during vicious selling episodes it morphs to fear. Finally, it all ends in capitulation for many.

This is a sad story—the mother of all unforced errors—except for the investor who refuses to overpay or overstay. In this refusal to overpay, we value cash as more than an asset that currently yields zero. In fact, it is those very low interest rates and the low expected returns from equities that make the opportunity cost of holding cash incredibly low. Cash effectively becomes a valuable call option on any asset with no expiration date and no strike price. Embracing the aphorism, “One man’s trash is another man’s treasure,” the value investor’s unwavering exercise of patience and rationality engenders a temperament of imperturbability—often the trait that makes the difference. To be sure, there are pricing anomalies even in rich markets. They’re just harder to find.

Someday investors can once again do well picking stocks by simply throwing darts at the Wall Street Journal. Someday index funds will make more sense for the passive, buy-and-hold investor than they do today. Ironically, but most assuredly, when that figurative “day” of despondency and disillusionment comes, the unseasoned investor’s temperament will be anything but imperturbable. Low unforced error investing is “simple but not easy…”

 

Central Bank Buyback Program

Central banks are fixing, or at least significantly influencing, asset prices via their bond and stock purchases. But what about that saying that the markets are bigger than any government intervention? Isn’t this what the currency experts always say when a government intervenes in the currency markets?

Japan’s QE is 80 trillion yen a year, while the ECB’s is 960 billion euros a year. So that’s around $1.8 trillion a year. If global central banks were a corporation and we thought about their QE programs like a stock buyback, how much of the float are they buying a year? According to the McKinsey Global Institute total global debt outstanding as of Q2 2014 was $199 trillion. What is global stock market capitalization? $60-$70 trillion? So total global debt and equity capital globally is $260 trillion or so.

Thinking of QE as a buyback puts things in a very different perspective. The central bank giants look tiny versus the global financial markets, with their combined QE’s equaling only 0.7% of total global debt and equity outstanding. That’s a very small buyback program and would be almost unnoticeable for most companies. There would be a lot of upset shareholders!

Of course because QEs are focused on sovereign debt (“risk-free”), QEs consist of a much larger portion of government debt outstanding. And because so many investors use risk-free rates as their foundation of valuation, (especially relative value investors), it has had a significant impact on global asset prices. However, I still believe it’s interesting to think about from a buyback perspective. It shows the markets are considerably larger than the central banks and if asset prices ever misbehaved, it would be very difficult for the central bankers to find a monetary bazooka large enough to get investors and prices back to “appropriate” levels.

Lastly, as asset inflation grows and debt levels increase globally, the amount of QE relative to total debt and equity capitalization shrinks, making QE less effective, or buybacks a smaller percentage of the float. More central bank buyback announcements on the way!

Scenario Analysis

I’m always thinking like a credit analyst. One of the reasons for this is the discount rate I use in my valuation calculation is part credit risk and part equity risk. I determine my required rate of return on equity investments by asking how much I’d demand to lend to a business, then I add an equity risk premium to that. Historically what I’d lend to a small cap business has been 6-9%, while my equity risk premium has ranged between 4-6%. After adding the two together, my required rate of return on small cap equities has been 10-15%. Since the inception of the absolute return strategy I manage, I’ve achieved my equity return goals, which ultimately is my investment objective — achieving adequate absolute returns relative to risk assumed.

When thinking like a credit analyst and performing credit work, I’ve found scenario analysis to be a very beneficial tool. Scenario analysis attempts to consider all of the possible operating results a business expects to generate in a variety of operating environments. Not only does this help determine if I’ll get my money back as a creditor (or stock doesn’t go to $0), it is also essential in determining the normalized free cash flows I use in my valuation model. In essence, by considering and averaging a variety of outcomes, surprises are reduced and equity valuations are more accurate.

Given current corporate bond yields and equity prices, I do not believe there is a lot of scenario analysis happening on Wall Street these days. If scenario analysis is being performed, it appears investors have eliminated the possibility of a recession from their potential outcomes. I do not believe recessions are extinct. Given the age and character of the current economic recovery, I believe a future recession is inevitable and should be included in any scenario analysis.

Considering how long it’s been since the last recession, it’s understandable why many investors may have forgotten how recessions significantly alter business operating results and the investment landscape. It might be healthy to remind ourselves what a recession looks and feels like. Instead of looking at old government economic data, I thought it would be more effective to look at a recession through the eyes of a business. Specifically, I’d like to focus on Hanesbrands (HBI), the leading provider of underwear and activewear.

On Monday I talked about a highly cyclical business, Kennametal. While I believe I can illustrate how a recession feels more dramatically with an industrial company like Kennametal, I want to emphasize that all businesses are correlated to the economy, not just highly cyclical companies. I think this is especially important today given the overvaluation and crowded positioning in high quality and less cyclical stocks.

Another reason I wanted to focus on Hanesbrands is something caught my attention during their recent conference call. Management mentioned that, “Roughly two-thirds of our debt is now fixed and we have a blended interest rate of approximately 3.6%.” The 3.6% interest rate really stood out to me. That’s amazing, I thought, even in today’s extremely easy credit environment. I suppose I’m a little more surprised than most as I vividly remember when Hanesbrands’ stock was trading at $2 during the last recession in 2009. Things were getting pretty dicey for them and the industry. They ultimately survived, but I’m surprised the scars weren’t more noticeable for newbie bond buyers lending the company money out to 2024 and 2026. In my opinion, given the low coupons on this debt, they’re either not performing a scenario analysis, or they aren’t including a recession as a real possibility.

Although Hanesbrands’ business is more stable than most, they were not immune to the last recession. Please join me in going down memory lane to Q1 2009. It was Hanesbrands’ last trough in operating results and the last U.S. recession. Instead of credit being thrown at them by investors only demanding an average yield of 3.6%, Moody’s was downgrading Hanesbrands’ debt and amendments were being made to loosen credit covenants. A business that is considered a stable consumer staple by some, reported sales declined 13% and EPS declined to -$0.20 vs. $0.38 due to “weak consumer demand related to the difficult economic and retail environment.”

The following is from Hanesbrands’ April 4, 2009 10-Q. It’s a thorough description of their operating environment and the last recession.

The ultimate consumers of our products have been significantly limiting their discretionary spending and visiting retail stores less frequently in the recessionary environment. We are operating in an uncertain and volatile economic environment, which could have unanticipated adverse effects on our business. The retail environment has been impacted by recent volatility in the financial markets, including declines in stock prices, and by uncertain economic conditions. Increases in food and fuel prices, changes in the credit and housing markets leading to the current financial and credit crisis, actual and potential job losses among many sectors of the economy, significant declines in the stock market resulting in large losses to consumer retirement and investment accounts, and uncertainty regarding future federal tax and economic policies have all added to declines in consumer confidence and curtailed retail spending. We also expect substantial pressure on profitability due to the economic climate, significantly higher commodity costs, increased pension costs and increased costs associated with implementing our price increase which was effective in February 2009, including repackaging costs.”

I know this is a lot to chew on, but I think this is important for several reasons. First, in my opinion, risk assets are priced as if the above operating environment will never happen again. Or if it does, those overpaying will see it coming and avoid the carnage by being the first ones out. I’m not so sure on both assumptions. I believe the above will happen again and I also believe everyone can’t be the first ones out. Premiums for assuming risk are necessary and should be demanded by investors, not ignored and forgotten.

Second, many investors are currently crowding into consumer stocks, like Hanesbrands, assuming they’ll be safe during the next recession. Given the prices investors are paying, I believe investors seeking shelter in low risk businesses are increasing risk, not escaping it. I think it would be a helpful exercise if investors reviewed company results during the last recession and considered similar scenarios when measuring risk and valuing risk assets. Just because a company is labeled or categorized as a consumer stock or “recession-proof” doesn’t mean they have been or will be. All companies are cyclical to some degree and no one is immune to major dislocations in financial markets and the economy.

Based on record stock prices and the absence of risk premiums, investors have clearly forgotten 2009 and how close many companies came to the edge. I think it’s important to remember the last recession and why it came about. During the last cycle, investors collectively believed in some really silly things and extrapolated those beliefs far into the future. I believe the same thing is happening this cycle, but the beliefs are even sillier (unwavering confidence in central bank policy and T.I.N.A. are two of my favorites).

Have any of the problems that created the last recession really gone away? Excessive leverage is what created the last recession. Considering debt levels are currently higher than last cycle, it seems within reason that the next recession could be of similar magnitude and even longer in duration. One scenario I see possible is the next recession will begin due to failure of unprecedented central bank monetary policies. If the next recession is caused from central bank policy failure, the creator of the next recession (they were also the creator of last recession) would be too impaired or too discredited to replicate the 2009-2016 “V” shaped market recovery and subpar economic recovery. If the next recession is lower for longer, how will corporate credit perform? If results are anything similar to the last recession, holders of 3%-5% yielding BB corporate debt may be in for a rude awakening.

Fake Rolex

Many years ago I was walking into a client meeting with a colleague. Right as we walked into the client’s office the sole of one of my shoes came completely off. I looked over at my colleague and he just shook his head in disgust and said, “Value managers.”

I guess I’ve never been one to pay up for attire. My favorite suits come from Stein Mart (SMRT). I can’t tell the difference between a nice suit and a $199 (was originally $599!) Stein Mart special. I don’t wear jewelry or watches either. But if I did I’d like a Rolex. Not to impress, but from my understanding they hold their value (another cash hedge). One thing is certain, if I paid up for a Rolex, I’d want the real thing.

Given the prices of stocks these days, investors are certainly paying up and then some. What are they paying up for and are they getting the real thing? I suppose they’re paying up for future growth, since prices make absolutely no sense based on current growth trends. While outlooks for organic growth don’t appear encouraging, easy comparisons should help businesses pull out of their earnings recession later this year.

A company we talked about in depth yesterday, Kennametal (KMT), should see their comparisons become easier over the next several quarters. This may be one reason why investors have driven Kennametal’s stock up from its lows – they believe the worst may be coming to an end. Other cyclicals and industrials should also start benefiting from easier comps.

Business is still challenging for many industrial companies, but assuming nominal GDP stays near 1-2%, business trends should show signs of stabilizing, albeit at a lower level. Kennametal is a good example. Business remains weak with organic sales declining 8% last quarter, but management noted inventory destocking by its customers appears to be easing.

Management stated, “End-market wise it’s really pretty tough out there across the range of end markets. I guess I would say on the industrial side — aerospace, maybe automotive to little bit of an extent, and infrastructure — pick your poison. Mining, commodities, the only positives I think are a little bit in the earth works kind of business, some on the construction side. Just general, it’s tough to get ahead of the prior-year.

The good news I think, as we look forward, is that we have a little bit easier comps to go against. But you know, one of the concerns we have is that while we’re calling our revenue to be basically flat year over year, we are not sure how confident for us to really be on that. So that’s in fact one of the reasons why we were a bit more aggressive on thinking about further cost reduction.”

The question for Kennametal investors (and investors of other cyclicals) is has the stock gotten ahead of the “good news” of easier comparisons. Management expects to earn $1 to $1.40 next year. That’s quite a big range, which implies a lot of uncertainty. Trading at $27.50/share and a balance sheet I’m not particularly comfortable with ($100 million 2017E free cash flow vs. $540 million in net debt), many beaten down cyclicals don’t look so beaten down these days.

While comparisons should get easier as we go through the second half, I think it’s important not to confuse real economic growth (real Rolex) with easy comparisons (fake Rolex). This also relates to earnings estimates. Although most companies beat earnings estimates again this quarter, overall results and demand were stagnant – similar to Q1. With GAAP P/E’s in the mid-20x range for many stocks (even higher if cyclically adjusted), stagnant growth isn’t going to cut it, no matter how earnings look relative to estimates.

Current equity valuations require growth above and beyond easy comparisons. In my opinion, growth needed to justify lofty equity valuations must come from a real increase in demand, not simply bounces off the bottom of an earnings recession. In other words, for valuations to make sense, stocks need a sustainable increase in economic activity to generate strong organic growth. Where will this growth come from? What industry is poised for a strong rebound in organic growth? If growth doesn’t rebound sharply, how can current valuations be justified? These are good questions that I can’t answer. Hence, my positioning.

The Wall Street Locust Swarm

When something can’t be found at our house, I’m usually accused of throwing it in the trash. I admit I don’t like clutter, but just because this is true doesn’t mean I throw everything away. Kennametal (KMT) is proof of this. Kennametal manufactures precision-engineered metalworking tools and components, surface technologies and earth cutting tools. Kennametal has been on my possible buy list for years if not over a decade. I’ve followed them for as long as I can remember, but I’ve never owned them. Given their highly cyclical business and tendency to take on debt, I don’t expect to own them in the near future. For me, they are the definition of investment clutter.

Why do I keep investment clutter on my possible buy list? There are times I follow companies with debt if it’s a business I like and would consider purchasing assuming debt is reduced. Kennametal fits this description. Deleveraging sometimes occurs when new management comes in with a different financial mindset and capital allocation plan. Other times existing management becomes so financially distressed, they scare themselves into paying down debt and swear off excessive leverage in the future. I also like following Kennametal because they sell to several important industries and provide good detail on their end markets (transportation, energy, aerospace, general engineering, and earthworks).

I often hear or read about how balance sheets have improved since the financial crisis. Maybe for a few mega caps this is true, but for the average company this isn’t what I’m observing. In fact, I think balance sheets are worse. The often cited McKinsey study supports what I’ve noticed from my bottom-up analysis. According to McKinsey global debt has increased $57 trillion since 2007 through Q2 2014. Corporate debt has grown from $37 trillion to $58 trillion.

Given slower than normal sales growth this cycle, many companies have resorted to financial engineering to enhance sales and earnings growth. Debt is often used to acquire, buy back stock, and pay dividends. Kennametal has done all three this cycle and yes, their debt has increased.

I’m not in favor of highly cyclical companies taking on debt. Cyclical companies are called cyclical for a reason – they have volatile operating results with exhilarating booms and terrifying busts. For example, Kennametal generated EPS of $3.83/share in 2012 and lost -$4.71/share in 2015 (large charges). Guidance for fiscal 2017 is $1 to $1.40. Pick a number, any number! In my opinion, volatile earnings and cash flows do not mix well with high debt levels and their associated fixed cash costs.

While I’d prefer to own a high quality stable business at a discount, there’s nothing wrong with investing in cyclical businesses. I’ve owned several high quality cyclicals in the past and follow many. In fact, their volatile operating results often create stock price volatility, which can lead to opportunity. However, when investing in cyclical businesses, I have some golden rules. First, never extrapolate the booms or the busts – normalizing cash flows for valuation purposes is essential.

Second, during booms you must sell – do not buy and hold a cyclical stock. Sounds easy, but booms can be so intoxicating that making a sound investment decision becomes increasingly difficult as the stock and your adrenaline soar (investing under the influence, so to speak). I’ve found highly cyclical businesses are usually very overvalued or undervalued, but rarely priced just right. Take advantage of the volatility and don’t get greedy. And if you miss the boom or sell early, do not fear, cyclicals are the home of second chances.

Third, I only buy cyclicals with strong balance sheets. Buying a cyclical at a discount is irrelevant if the business can’t survive the cycle. As I’ve said hundreds of times in presentations to clients, I never combine operating risk and financial risk — I’ll take one or the other, but never both. Absolute return investors cannot have investments go to $0. Doing so is a serious investment crime for an absolute return investor. Thankfully my record is clean!

Why do so many cyclical companies take on debt? Most cyclical businesses are in mature industries. Markets like energy, auto, mining, and aerospace typically grow in-line with nominal GDP over an economic cycle. Under pressure to generate growth, mature cyclical companies often turn to acquisitions to expand market share. This is usually where most cyclicals get into trouble. We saw this most recently in the energy industry. Exploration and production (E&Ps) companies acquired land and invested heavily in energy service capital expenditures. The industry’s debt levels exploded higher with several E&Ps now in bankruptcy.

Similar to what happened in the energy industry, acquisitions and heavy investments are often done during the peak of the cycle when cash flows and credit are most abundant. As excessive capital and credit chases limited deals, many companies are eager to and are encouraged to spend well beyond their means, driving up financial risk along with acquisition prices.

Kennametal is a good example. During their last earnings boom, they made a large acquisition and took on debt. In November 2013, Kennametal acquired TMB (producer of tungsten metallurgical powders, tooling technologies, and components) for $607 million. The TMB acquisition expanded Kennametal’s “presence in aerospace and energy end markets.” Goldman Sachs was the advisor. In 2012, TMB had $340 million in revenue, $37 million in operating income and $45 million in EBTIDA. So Kennametal paid 2x sales, 16x operating income and 13.5x EBITDA. These are very expensive valuation multiples for a cyclical business. Kennametal also paid well over book value as they took on a large amount of goodwill for the deal ($244 million).

Shortly after the acquisition, Kennametal announced it would take restructuring actions and expected charges of $40-$50 million resulting from the acquisition and higher than expected TMB inventories. Charges at Kennametal continued as the boom it was enjoying in 2012 turned into a bust (several of its end markets are now in recession). Kennametal took a pre-tax impairment charge to goodwill of $153 million in March 2015 and another impairment of goodwill in December 2015 of $375 million.

Another reason cyclicals take on debt is they generate considerable income and free cash flow during their booms. This sounds counterintuitive. Shouldn’t high profitability and strong cash flows reduce debt? It should, but excess cash flow is often considered excess capital that many shareholders believe should be returned to owners. Company board of directors are under considerable pressure to do something when cash builds. Excess capital built during a boom also gives boards and management confidence – often too much confidence – to invest, acquire, or return capital. Similar to investing, large capital allocation mistakes are often made at the top of a business cycle, not at that bottom.

I like the idea of returning excess capital to shareholders, but when highly cyclical companies distribute cash, they often return too much and can quickly go from capital surplus to capital deficit. Once boom turns to bust, some cyclical companies that were making acquisitions or returning capital to shareholders are suddenly forced to raise high cost capital in order to survive (recent equity issuance by energy companies after stocks declined sharply is a good example). Insufficient capital and liquidity during busts can also cause businesses to be managed too defensively and can frighten away customers due to service or counterparty risk concerns.

In my opinion, too many activists, buy-side analysts, and sell-side analysts encourage and contribute to short-term thinking and poorly timed capital allocation decisions. I call them the Wall Street locusts. The Wall Street locusts are always on the lookout for a healthy balance sheet to devour and destroy before moving on to the next green pasture. I find this to be an interesting comparison to the pressures of holding cash in a portfolio when prices are high. Some investors want the portfolio manager to buy something with the cash, even though it may mean overpaying and result in future losses. Activists and analysts apply the same pressures to managements of cyclical companies. Acquire, buyback stock, or pay a dividend, but don’t just sit there with a strong balance sheet.

I disagree with the Wall Street locusts. In my opinion during booms, when free cash flow is high and capital is being accumulated, a highly cyclical company would be better served by retaining capital and liquidity. I believe capital would be better utilized during the bust to maintain adequate investment and spending. Furthermore, a strong balance sheet enables cyclical companies to not only survive, but thrive during recessions. A company with available capital is better able to acquire attractively priced competitors that may be distressed from overextending themselves during the boom. Assuming sufficient capital and liquidity, I also believe buybacks are reasonable uses of capital at troughs of cycles (when prices are most attractive). Imagine being an energy company currently with a debt free balance sheet and a large cash balance. Unfortunately, most of the energy industry is frozen and distressed because they leveraged up during the boom instead of preparing for the opportunity of the bust.

In my opinion, some activists, buy-side analysts, and sell-side analysts are not looking out for the best interest of public companies as their intentions are often short-sighted. In effect, they want a quick return on their investment and don’t plan to be around during the next bust. The activists usually want major change to the business structure that investors will view favorably, resulting in a higher stock price. Structural changes are often accompanied by major changes to the balance sheet. The buy-side is typically less aggressive than activists, but still encourage buybacks and dividends, even near cyclical peaks (after they’ve become shareholders). The sell-side likes acquisitions as they often come with debt and investment banking fees.

Instead of caving into pressure from Wall Street, I believe cyclical companies should think long-term (over an industry cycle) and fight demands from short-term investors whose recommendations are self-serving and are harmful to the balance sheet. A weak balance sheet not only increases the risk of bankruptcy during the next recession, it also reduces operational flexibility, detracts from investment, and may place the firm at a competitive disadvantage. In effect, companies that need liquidity to survive and prosper though an industry cycle need to prepare their balance sheets during the boom so they won’t be at an operational and financial disadvantage during the bust.

In fiscal 2013 and 2014 Kennametal bought back $135 million in stock. During that period its stock traded near $40 on average, significantly above today’s price of $27 and its recent low of $15. Kennametal also paid $165 million in dividends in fiscal 2013-2015. Kennametal has $700 million in debt ($540 million net debt) and $150 million in pension liabilities. Total equity is $1.17 billion, but a large portion of this ($514 million) is goodwill and intangible assets. If Kennametal didn’t make the large acquisition ($607 million) during the peak of its cycle, along with buying back stock and paying a generous dividend, they’d have a debt free balance sheet and excess cash right now. A debt free balance sheet would put them in an extremely advantageous position during today’s difficult operating environment. They could either acquire or buyback stock at much more attractive prices. Instead, they’ll need their free cash flow ($100 million 2017E) to continue to pay for past capital allocation decisions.

In conclusion, cyclicals can be great investments, but understand and manage the risks. Don’t extrapolate booms or busts and avoid leveraged balance sheets. And if you’re a cyclical business, don’t give in to the Wall Street locusts. Avoid the swarm and protect your balance sheet. You’ll be in a much better position to not only survive, but act opportunistically during your industry’s next inevitable bust.