Profit & Market Cycle Lag

Stocks rallied sharply today in the face of weak economic data. Last Friday investors were thrown off by central bankers hinting at a rate increase. This week things are back to normal with easy money speeches and poor economic data. In other words, the Fed won’t or can’t hike interest rates. Asset prices rejoice. How many times have we been through this?

I found the retail sales report interesting. It appears government data is catching up with what I’ve been documenting on this blog – the consumer is struggling. Bloomberg reported, “Receipts declined in eight of 13 retail categories in August. After charging through the second quarter, the consumer is showing signs of exhaustion at the start of the second half of 2016.” Why pay an economist seven figures when you can get more accurate economic data from a bottoms-up absolute return manager (for free)? I’m joking of course. Most economists’ salaries are probably in the six figures.

Company operating results and economic reports are confirming the economy remains stagnant, if not weakening. Nonetheless, equity prices don’t seem concerned and remain near record highs. The current period reminds me a lot of 2007 when I began noticing a similar slowdown in business operating results. As is the case today, for the most part, stock prices ignored declining profit trends. It wasn’t until late 2008 when stocks eventually crashed and we found ourselves in the middle of a severe recession.

According to the U.S. Bureau of Economic Analysis, corporate profits peaked during the last profit cycle in Q3 2006. If you view the chart below (link), you’ll see a gradual decline in corporate earnings up until Q3 2008 when profits suddenly collapsed. Now turn your attention to the current profit cycle. According to this chart, the current profit cycle peaked in Q4 2014. Based on my bottom-up analysis, I thought profits peaked in Q3 2014, but it’s close enough (for government work). As you can see, the profit trends from Q3 2006 – 2008 and Q4 2014 – 2016 are very similar. Interesting.

In conclusion, corporate profits and stock prices are correlated, but there has been and can be a considerable lag. While there’s a similar pattern occurring this cycle versus last cycle, how long the current disconnect between profits and stock prices persists is unknowable. It will be interesting to see when and at what level the current profit cycle troughs and if stocks will notice. I think they will. Call me old-fashioned, but I continue to believe fundamentals matter, even if there’s a lag.

Have a great weekend!


Consumer Alert

During the upcoming earnings season, I plan to be very focused on the health of the consumer. As I’ve discussed in previous posts, I’m noticing increasing signs of a weakening consumer and I want to determine if a new trend is being established. Last week, Tractor Supply (TSCO) had some interesting comments I thought were worth highlighting. Tractor Supply is a retailer focused on recreational farmers, ranchers, and rural communities. The company operates 1,542 stores in 49 states.

On September 8, Tractor Supply preannounced lower than expected third quarter operating results. Same store comps are now expected to be flat to -1%. Tractor Supply’s stock declined 17% on the news. Even after its decline, Tractor Supply’s stock trades at 22x earnings and 14x EV/EBIT — another sign of the times.

A day after the preannouncement, the company presented at a Goldman Sachs conference. I thought some of their comments were helpful in better understanding current business trends. Management communicated that some of the headwinds they’re facing have accelerated and that there are three areas of weakness.

The first area of weakness was in energy-producing regions, which shouldn’t be a surprise. However, what was surprising, at least to me, is the slowdown has accelerated. Energy prices have been under pressure since the end of 2014. Why now? Management said, “While there has been an impact to some of the energy-centric stores for the past several quarters, it is no longer just in the energy-related categories and appears to be more impactful throughout the region.” In other words, the weakness is spreading. I think this is important as I would have expected comparisons in energy-producing regions to get easier. The fact that the weakness has accelerated and spread is an important data point, in my opinion.

The second area of weakness was in the agricultural regions. Similar to energy, management noted the weakness caused by lower agriculture incomes is spreading. Management stated, “Our core customer is generally not the commercial farmer and our business has not been strongly correlated to agricultural economy. However, we do have stores in many of these areas and we believe that three consecutive years of declining farm income and increasing uncertainty in ag communities maybe having a broader impact on the overall spending in these areas. It’s sort of a ripple effect or a halo, if you will.

Lastly, management noted warm winter weather impacted heating-related products, like wood burning stoves and log splitters. I’m not sure there’s much useful data to derive from these comments except when the weather is warm and heating oil is cheap, there’s less need to burn wood.

Management had positive comments as well and stated, “…we are seeing solid sale trends in the West and the Southeast regions where there is less exposure to the energy and agricultural markets. In addition, we continue to see strong demand for many basic items such as Livestock and Pet, which are comping up mid-single digits company-wide quarter-to-date.”

In the Q&A session, management provided additional detail on the consumer saying, “Well, when we look at the consumer, we talked a little bit in the prepared remarks about really the center of the country and driven mostly by energy production as well as the farming income. And seeing that those economies are soft, it appears to us that the consumer is taking a little bit of a breather. And so that obviously impacts our perspective on the back half of the year. It’s difficult right now to assess how long that will be, maybe there’s anxiousness over the political environment. People are just pausing a little bit to say, hey, what’s going to happen next year? And take a little bit of time.”

Tractor Supply’s comments and results are similar to what many other consumer companies are reporting. Cracker Barrel (CBRL) is a good example. Today, Cracker Barrel reported weaker than expected 2017 guidance and negative traffic trends. In the Q&A session management commented on the consumer saying, “In terms of the consumer, our – it’s a difficult subject to get any strong conviction about where it’s going. If I had to say overall, it just feels like many consumers – it’s an uncertain environment. The source of uncertainty seems to differ, depending on who you are and your situation. So for some, it may be the political rhetoric, for others, it may be their personal employment situation, for some, it may be healthcare costs, for some, it may be figuring out how to save for retirement. But overall, it does feel like despite the fact that there certainly are signs, some signs that would suggest that consumer is stronger, but it does feel like it’s very uncertain and that they’re holding back at least in their spending in the restaurant sector.

Tomorrow the government releases August retail sales data. I’ll read the report, but I remain more interested in what consumer companies are experiencing and what their customers are doing. Regardless of whether tomorrow’s retail sales report is weak or strong, my opinion on the consumer won’t change. In my opinion, bottom-up data continues to be more timely and accurate. As it relates to the consumer, the data is getting more convincing that the consumer is slowing, but I’ll save my judgement until after this earnings season. I expect to learn a lot more soon.

Put Down the Spoon

Whether or not this is the peak of the current market cycle, we don’t know for certain. But we do know that valuations are expensive based on historical averages and are near past cycle peaks. As such, I believe it’s a good time to consider peak cycle positioning.

Given overvaluation is so broad this cycle, I continue to believe the best positioning is patience. There simply aren’t many assets that haven’t been artificially inflated by 0% rates and countless global QEs. Being very familiar with my opportunity set, I concluded that it made more sense to incur possible opportunity cost than to overpay and risk permanent loss of capital. As a result, I moved to 100% cash a couple of months ago. In effect, why should I overpay if I don’t have to? While this positioning makes sense to me, I’m aware it isn’t practical for many investors, especially professional investors playing the relative return game.

I’m probably as far as it gets from being a relative return investor. However, if I had to play the game and I was forced to invest in today’s market, I’d do my best to avoid what’s working. Avoiding what’s working and expensive has served me well in past cycles. What’s working near market peaks is often what incurs the most severe end-of-cycle losses.

During the past two market cycles, many of the stocks that were working were also some of the largest weights in benchmarks. This isn’t unusual as the more popular (expensive) a stock becomes, the higher its market cap and the larger its weight in the benchmarks. Considering indexing has grown considerably this cycle, it will be interesting to see how the what’s working stocks perform once market trends and investment flows reverse.

I think we saw a snapshot of this last Friday, when some of the more popular stocks generated above average losses. Bloomberg touched on this yesterday in the article, “Safety Trade Leaves S&P 500 on Knife’s Edge as Valuations Soar”. The article noted how some defensive stocks declined more than the market and that their valuations are elevated relative to their 10-year average.

Bloomberg also pointed out something I wasn’t aware of and found very interesting. Specifically, many of the high-quality defensive stocks that have been performing well are now included in momentum strategies. The Bloomberg article states, “Take the iShares Edge USA Momentum Factor ETF, for example: the two groups [utilities and phone shares] now make up 15 percent of holdings in that fund, compared with less than 1 percent at this time last year.” Wow. And it gets even more interesting. I visited Morningstar’s website and discovered the “consumer defensive” and health care sectors represent 30.6% of the fund. Add this to the 15% utilities and phone weight and high-quality defensive stocks make up almost half of the fund’s assets. Again, this is a highly-ranked momentum fund and almost half of the portfolio is filled with so-called defensive stocks (utilities, consumer defensive, and health care).

The mystery behind why high-quality defensive stocks are performing so well and are so expensive has been solved. Everyone owns them! Value managers own them, index funds own them, dividend funds own them, low volatility funds own them, and now even momentum funds own them. Apparently avoiding what’s working isn’t a popular strategy at this point of the market cycle. Near market peaks, it never is.

I understand how difficult it is to avoid what’s working. As a portfolio manager, your job is on the line and you’re judged from one quarter to the next. When you have client meetings, talking about what’s working is so much easier than talking about what isn’t. Own what’s working and get pats on the back or invest differently and spend an hour defending yourself. For most in the industry, it’s is an easy decision. It’s like deciding between ice cream and spinach.

Avoiding what’s working is not easy, especially this cycle since a lot of what’s working are high-quality businesses. When markets became overvalued during the past two cycles, quality was often one of the few areas absolute return investors could selectively find value. Many investors in 1999 and 2007 were chasing lower quality and higher risk investments. What was working was more speculative and easier for disciplined value investors to avoid. Today quality is being chased and it is quality that is working. I want to own quality and I bet you do too. Unfortunately, it is also quality that is expensive and it is quality that I’m avoiding.

When you’re in the second longest bull market in history, it’s easy to forget that market cycles end. But they do end and navigating through them successfully is extremely important. The end of a market cycle can make or break a professional investor. Thousands of basis points of performance can be gained or lost in a matter of weeks. If patience isn’t an option, I believe avoiding the crowd is something worth considering.

No Bubbles Greenspan, Bernanke…and Lockhart

During the tech bubble, Alan Greenspan justified extraordinary asset inflation by convincing himself and others that the economy was benefiting from a productivity miracle. He didn’t see an asset bubble, only a tech-driven productivity boom. It was a convincing argument to many, but in the end it was an asset bubble and as all asset bubbles do, it popped. During the housing bubble, Ben Bernanke convinced himself and others that housing prices were supported by fundamentals. He said declining home prices were a “pretty unlikely possibility” and that “we’ve never had a decline in house prices on a nationwide basis.” It was a convincing argument to many, but in the end it was an asset bubble and as all asset bubbles do, it popped.

Today, Bloomberg reported that Dennis Lockhart from the Federal Reserve Bank of Atlanta said, “I can’t say that there is any asset market that I would consider in bubble territory at the moment.” Not aware of any asset bubbles? Interest rates have never been this low in the history of mankind. How does that not at least deserve an honorable mention? Equities are probably a little more debatable than bonds, but based on valuations, I could argued they too are in bubble territory.

Can we at least agree there were asset bubbles in 1999-2000 and 2005-2008? Stock market declines of 40-60% should qualify, right? And if it’s safe to categorize the past two cycles as bubbles, why wouldn’t similar valuations qualify today’s market? Certain valuation measures that I prefer, such as price to sales, suggest the stock market is currently as or more expensive than past cycle peaks. Valuations of the average stock are particularly high this cycle given the broadness of overvaluation. This shows up well in median valuation measures. According to Goldman Sachs, the median stock was trading in the 99th percentile of historical valuations as of May 12, 2016 (100 percentile EV/sales and 99% percentile EV/EBITDA).

I’ve also noticed the broadness of overvaluation in my opportunity set. At 26x earnings and 2x sales, in my opinion, the average stock on my 300-name possible buy list is more expensive today than the past two equity bubbles. Considering we are closer to the peak of the profit cycle, valuations are even more expensive when viewed from a normalized perspective. Based on my bottom-up valuation work, I see no reason why many of the small cap stocks I follow couldn’t decline 50% — similar to past peak to trough declines (a decline from 2x sales to 1x sales would simply revert many valuations to historical norms).

Bond yields are at their lowest levels in thousands of years. If equity valuations were to revert to their mean, equity prices would incur similar declines as the past two bubble cycles. Meanwhile, Mr. Lockhart isn’t aware of any market that is in bubble territory. I suppose we’re all entitled to our opinions, but if I was a central banker, I’m not sure I’d want to join the lifelong There’s No Bubble Club. Instead, I would point out current yields and valuations relative to history, and allow Greenspan and Bernanke to keep their exclusive membership.

Friday — Test Run or Real Deal?

I’m really looking forward to earnings season. It’s over a month away, but I’m very curious how companies are performing and if we’re going to have another quarter of negative earnings growth. Will the sixth consecutive quarter of declining earnings be the straw that breaks this cycle’s back? I wish I knew. We’ve been through this so many times. As soon as fundamentals appear to be gaining the upper hand, central banks intervene and asset prices reassert their upward trend.

That wasn’t the case on Friday when asset prices went off script. Price declines weren’t caused by fundamentals, but were driven by statements and concerns arising from the major central banks. In Japan there is growing uneasiness about negative rates and a flattening yield curve. According to Bloomberg, “Kuroda has noted that low long-term yields would hurt return on pension and insurance investments.” Adding to policy uncertainty further, Mario Draghi announced on Thursday that there would not be additional monetary stimulus in the near future. The ECB’s inaction was unsettling to investors who have become conditioned to expect more from each monetary bazooka blast. Finally on Friday, Eric Rosengren from the Boston Fed cautioned that if the Fed waits too long to raise rates the U.S. economy may overheat. As a result of his comments, the probability on an interest rate hike in September increased, unsettling investors even more.

As stated in previous posts, I do not believe this market cycle is perpetual. Fundamentals have already shifted and the profit cycle is in decline. Currently, inflated asset prices are being supported by the perception of an unlimited central bank bid. It’s been my belief that this bid is unsustainable and free markets will return once central bank policy is determined to be counterproductive. What’s interesting about last week is it was policy makers, not investors, questioning the effectiveness of monetary policy. Why would central bankers intentionally create financial instability by appearing less confident about their own policies?

After eight years of emergency monetary policy and historic asset inflation, there’s no shortage of experts on central banking. However, how can the experts have strong opinions when the central bankers themselves seem so unsure? Based on their conflicting and ever-changing statements, they appear to lack a cohesive plan. With so many central bankers speaking from one day to the next, it’s often an inconsistent and confusing message. It’s become quite a circus. This is one more reason why I continue to avoid making investment or business valuation decisions based on monetary policy and the current interest rate environment. It’s unstable, unpredictable, and is not based on fundamentals – it’s pure speculation. As stated in previous posts, I do not believe allocating capital in today’s markets is investing (see August 15 post “Is This Investing?”).

I found Eric Rosengren’s comments on Friday regarding the potential for the U.S. economy overheating particularly puzzling. What data supports this? What domestic industry is currently overheating or ramping up? Examples Mr. Rosengren, please give us specific examples (see July 22 post “Examples Please”). Maybe his comments were meant to build confidence in the economy, I’m not sure. But one thing is certain, asset prices didn’t like it. Whatever confidence was built from his statement was more than offset by a sharp increase in financial instability (VIX increased to 17.50) and lower asset prices.

I continue to view the economic environment through a bottom-up lens and provide specific examples to back my findings and beliefs. As I reported last week, I have been noticing increasing signs of a slowing consumer. While Mr. Rosengren is concerned about an overheating economy, I see the opposite. I see a stagnant economy and a consumer that could be rolling over.

Kroger announced earnings on Friday and had a few comments on the consumer that caught my attention. I’m assuming Mr. Rosengren wasn’t on the call or the hundreds of other calls and earnings reports I reviewed over the past few months. From Kroger’s conference call, “Customer insights give us a big advantage in challenging environments like this one. A lot of what we are seeing suggests a gradual tightening of budgets. Our customers tell us they are less confident about the economy now than they were three months ago, and they expect the economy to get worse in the next three months.” The data dependent Fed continues to confuse me as many of their statements conflict with what most companies are experiencing.

Confusing and conflicting messages from central bankers were partially responsible for Friday’s selloff. It was a very broad decline in asset prices (stocks, bonds and commodities). Very few assets avoided the decline – even the “safe havens” were hit. As I discussed in the post “High Quality Risk” last week, quality is expensive and I don’t believe it will act as a safe haven this cycle. While only one day, Friday’s declines support this view. According to Bloomberg, “Shares of defensive stocks led declines on U.S. exchanges as trades that investors piled into in search of dividend yields reversed amid the spike in Treasury yields. Utilities and phone stocks plunged more than 3.4%, while real-estate investment trusts tumbled 3.9%.” Interestingly, the PowerShares S&P 500 low volatility ETF was more volatile than the market, declining -2.95% vs. -2.45% for the S&P 500.

I can’t predict or time financial markets. However, I found Friday to be very interesting. As noted previously, the selloff was very broad. As everything went up together this cycle, I see no reason why everything can’t go down together. Almost every asset class has been inflated by eight years of central bank emergency policies. It truly is an Opportunity Set From Hell (see July 8 post). As such, I believe all assets that have been mispriced by unsustainable monetary policy will be affected once this cycle ends. But this cycle will end. Make no mistake about that. Friday may not be “it”, but I believe it was a good test run for the day when central bank policies are deemed counterproductive and The Great Normalization begins. With few if any safe havens in stocks or bonds, I continue to be positioned accordingly and remain 100% patient.

Dodo Bird Article Now in Captivity

Absolute return investing goes in and out of favor. After 2009, thinking like an absolute return investor became very popular. Currently relative return investing has the upper hand. Actually, I’d argue “whatever” investing is today’s most popular investment strategy. After a portfolio manager gives a presentation the potential client says, “Whatever, put me in an ETF.” Why even bother with absolute or relative return active managers at this point of the cycle? Central bankers are clearly in control. Avoid the fees and ride their wave.

I’m not going on a rant about central banker asset inflation today. We all know what’s going on. Instead I’d like to share an article that was sent to me by a fellow absolute return investor. One of the things I’ve enjoyed most about writing a blog is being introduced to so many experienced and like-minded investors. Some readers are absolute return investors, while others work in the relative return world, but have similar concerns and beliefs.

Interestingly, I believe there are a lot of relative return investors that in their heart of hearts, think in absolute terms. They get it, they like it, but it’s not a practical way to make a living. Trust me, I understand this conflict all too well. When this cycle ends, I’m hopeful that will change. I look forward to the day when it becomes more acceptable to not only think in absolute terms, but to manage money to make money, not to imitate a benchmark or style box.

Back to the subject of the day. An absolute return article was spotted in early September. I was alerted to its location yesterday. Articles on absolute return investing at this stage of the market cycle are as rare as central bankers raising interest rates. You sometimes hear about them, but rarely, if ever, do you see one in real life. However, here it is. Previously thought to be extinct, we now have an absolute return article in captivity. To be fair, it wasn’t written by a journalist, but a professional investor, Larry Sarbit. After reading the article, I determined he’s a card-carrying absolute return investor and knows his stuff. Well done!

In addition to his case for absolute return investing, Mr. Sarbit makes an interesting point about expensive equity valuations in the public market versus valuations a rational business person would expect to pay. In effect, he’s pointing out the glaring difference between the very low required rate of returns investors accept in the stock market and the more adequate return demands of private business owners.

Many business owners in the private markets will think in terms of 20%-30% required rates of return. They want their original investment back in 3-5 years. However in the public markets, investors are willing to accept 3%-5% free cash flow yields on many mature businesses with limited growth. At those meager free cash flow yields, it would take 20-30 years to receive your original investment back.

Although there are obvious differences between public and private companies, I’ve always found the large difference between their valuations interesting. The difference seems particularly large this cycle, mostly due to the extreme valuations in the public markets. In any event, I rarely see it discussed in the financial media and it was nice to see it addressed in this article.

Have a great weekend!


And Give Me a Carton of Reds

During the last earnings season, I noted several consumer businesses were showing signs of deceleration. I wasn’t certain if it was a blip or a new trend. My plan was to monitor consumer companies closely and learn more. While it’s still too early to call it a clear trend, I continue to believe consumer companies are flashing yellow. Casey’s General Stores (CASY) earnings report provided us with another small, but interesting data point.

Casey’s General Stores (CASY) operates 1,900 convenience stores in 14 Midwestern states. Similar to many high-quality companies, I like Casey’s, but its stock is too expensive for me. At current prices, I believe Casey’s is a good example of high-quality risk, which I discussed earlier this week. Do not fear, I’m not doing another post on high-quality risk. I know we all like high-quality businesses. As such, I’m well aware that talking about their risks and their expensive valuations can be a painful subject. By the way, what portfolio manager do you know has ever told a client that they buy crummy low-quality businesses? Everyone’s holdings are high-quality, right? If everyone owns the good ones, who owns the bad ones? We’ll save that post for another day. For now, back to Casey’s.

Casey’s reported earnings yesterday. I thought results were good, but sales growth was slower than many investors were expecting. As a result, its stock declined 9%. It’s a good example of why investors should demand a margin of safety, even for high-quality businesses. Furthermore, it’s a reminder that while stock charts of many high-quality stocks suggest otherwise, the risks of their businesses have not disappeared. After their earnings release, I believe it’s safe to add Casey’s to the growing list of high-quality stocks recently disappointing investors.

Casey’s sales were less than expected partially due to a slowdown in cigarette sales. This is another recent data point, along with last week’s jobs report (the August report appeared closer to reality), that suggests the consumer may be under pressure. Casey’s comments on cigarettes may not seem like much, but these are the type of comments I search for when looking for a shift in trends. At the very least, I think you’ll find them interesting.

From Casey’s call today (management), “We’re seeing a moderation in cigarettes or a deceleration I would say, back into the mid-single digits. Also here what we have seen in this first quarter, we have seen a shift, albeit our carton movement is up relative to a year ago, we are seeing a slowing down in the carton movement. People are migrating back to the packs a little bit, also migrating a little bit away from our full value products to some of the more generic products.”

When times are good, you buy a carton of Marlboro Reds. When you’re concerned about your job or your income is stagnant, you buy a pack of generics. I can relate. My Marlboro Reds come in a different package. After a long day at the office (Starbucks) screening through overvalued stocks, I crave a carton of ice cream. When I was officially employed, I’d treat myself to the high-end stuff. These days, it’s Publix private label. In addition to being introduced to many like-minded investors, it’s one of my favorite pleasant surprises about writing a blog and being unemployed. It’s forced me to try new things. Publix ice cream – pretty good I must say. They even have organic!

Unlike Central Bank Balance Sheets, Corporate Balance Sheets Have Limits

Most of us are aware of the tremendous amount of groupthink in the investment management industry, but what about corporate America? Little is written about the pressures placed on boards of directors and corporate executives to follow the herd. Wasn’t corporate groupthink at least partially responsible for the last financial crisis? Who can forget Charles Prince’s quote, “As long as the music is playing, you’ve got to get up and dance.” Few in the financial industry sat out the housing/mortgage bubble dance.

More recently we had a capital expenditure and credit boom in the energy industry. There weren’t many, if any, industry participants that didn’t extrapolate the boom and participate in groupthink. The industry was obsessed with production growth. Exploration and production companies were all doing the same thing – borrowing and drilling.

In my opinion, the most popular corporate strategy this cycle has been acquisitions, stock buybacks, and dividends. Although some companies have done this with free cash flow, many have funded at least a portion of these capital outlays with debt financing. Corporate debt growth is a theme I’ve discussed in previous posts. I’ve used several company specific examples to illustrate how balance sheets, on average, have weakened this cycle. The energy industry is again the most glaring example, but other industries have also piled on debt. Even high-quality companies have put on a lot of balance sheet weight, such as J.M. Smucker, which I discussed yesterday.

The Associated Press (AP) published a very good article a couple of weeks ago titled, “The Hidden Risk to the Economy in Corporate Balance Sheets”. While I’ve seen aggregate debt leverage ratios and charts supporting what I’m noticing from a bottom-up perspective, the AP article has some additional stats I thought were worth highlighting.

Given the amount of debt growth I’ve noticed over the past several years, I continue to find it surprising that some investors insist that balance sheets are in better shape this cycle. The AP article points out that this misunderstanding is most likely a result of a few mega cap companies that in fact do have strong balance sheets. However, when viewing balance sheets in aggregate, it’s a completely different picture. The AP says, “Of the $1.8 trillion in cash that’s sitting in U.S. corporate accounts, half of it belongs to just 25 of the 2,000 companies tracked by S&P Global Ratings. Outside of Apple, Google and the rest of the corporate 1 percent, cash has been falling over the last two years even as debt has been rising. It now covers only $15 of every $100 they owe, less than it did even during the financial crisis in 2008 when finances were crumbling [my bold].”

Another debt statistic in the article was particularly interesting to me as it is how I think about leverage. Many investors measure leverage in terms of debt to EBITDA. While I monitor debt to EBITDA, I like to measure leverage differently. Specifically, I want to know how long it would take for a company to pay off all of its debt. I like monitoring debt in this manner as I never want to be at the mercy of volatile credit markets or a fickle banker. I want to know, if necessary, if the company can pay off its debt before its maturity wall hits.

My rule of thumb is for non-cyclicals to be able to pay off their debt in five years and cyclical companies to be debt free in three years. I believe by following this simple rule, I’m in a better position to limit balance sheet driven losses. As an absolute return investor I never want a stock to resemble a goose egg. Absolute return investors must avoid large mistakes. As the GEICO commercial says, it’s what we do.   

Do most companies pass my leverage thresholds? According to the AP article, the answer for most junk rated companies is no. “Companies whose debt is already deemed junk are in the worst shape in years. To pay back all they owe, they would have to set aside every dollar of their operating earnings over the next eight and a half years, more than twice as long as it would have taken during the 2008 crisis, according to Bank of America Merrill Lynch.”

Again from the AP article, another “not since the crisis” statistic, “The number of companies that have defaulted so far this year has already passed the total for all of last year, which itself had the most since the financial crisis. Even among companies considered high-quality, or investment grade, credit-rating agencies say a record number are so stretched financially that they’re one bad quarter or so from being downgraded to junk status.”

Finally, there is apparently an alternative to stocks (sorry TINA) – corporate bonds! The AP article states investors, “…put a net $22.8 billion into mutual funds specializing in corporate bonds in the 12 months through July, lifting total investments via such funds to $144 billion, according to Morningstar. The headlong rush reflects desperation for something a little more rewarding than the stingy interest paid by Treasurys and other traditionally safe bond offerings.”

With sales stagnant and earnings in decline, I don’t believe corporate organic growth is strong enough to rejuvenate the economy. Credit growth in one form or another will most likely be the drug of choice to get GDP growing again. With corporate debt at elevated levels by many measures, I don’t believe corporate balance sheets have sufficient capacity to provide the economic cycle with a second wind. While central bank balance sheets are unlimited, corporate balance sheets are not.

Yesterday I discussed J.M. Smucker and how their balance sheet’s leverage has increased. Given the stability of their business, I don’t believe J.M. Smucker is at risk of not making interest payments or becoming distressed. As long as they don’t do more acquisitions or aggressively buyback stock, I believe their bonds are sound (of course there’s still interest rate risk). However, considering the amount of debt they’ve taken on, I believe their flexibility in running the business has been reduced. Furthermore, increasing debt levels from here would move their debt above levels I’d consider comfortable, even for a stable business (it would exceed my 5x free cash flow/debt threshold). In effect, this cycle’s popular strategy of borrowing at 2%-4% to acquire, buyback stock, and pay dividends has its limit. In my opinion, many mature companies that have taken on debt this cycle are approaching it.

A large portion of the positive effects of piling on debt this cycle has already occurred. While credit remains very easy to obtain and is attractively priced, I expect corporate debt growth to moderate in the coming quarters. The decision to acquire competitors or buy back stock (especially near record prices) becomes much more difficult when leverage is already near 3-5x cash flow.

We may already be witnessing early signs of balance sheet exhaustion. For example, the pace of mergers and acquisitions during the first half of 2016 slowed. According to the StarTribune, “Na­tion­al­ly, there were 4,937 trans­ac­tions dur­ing the first half valued at $757.3 bil­lion, com­pared with 5,321 deals valued at $910.74 billion dur­ing the first six months of 2015, ac­cord­ing to Dealogic, which tracks mer­gers and public stock of­fer­ings.” The article points to expensive valuations and the Presidential election as possible reasons.

Buybacks have also slowed this year. According to Reuters, TrimTabs recently reported, “The value of stock buyback announcements from U.S. companies slowed to its lowest level in four years.” The article also stated, “The number of companies announcing buybacks has also fallen, averaging 3.3 a day so far, the lowest since the third quarter of 2013 and well below the 6.1 per day during earnings season a year ago.”

Did corporations suddenly become price sensitive as it relates to acquisitions and buybacks? I don’t think so. Borrowing at abnormally low rates to acquire and buy back stock can still be accretive for most companies, as long as their balance sheets allow it. However, there becomes a point when boards of directors and corporate executives say, “Maybe it’s time we give the balance sheet a rest.” I think many companies I follow are reaching that level now. I don’t believe they’re necessarily distressed (outside of energy) or in a hurry to reduce debt, but are simply more reluctant about adding to existing debt. After a period of aggressive balance sheet expansion, it’s only natural to reconsider future leverage. A corporate balance sheet pause would explain a lot and shouldn’t be surprising at this stage of the credit and market cycle.      


High-Quality Risk

High-quality stocks are very expensive at this point in the market cycle. It’s a topic I’ve touched on in earlier posts and in past quarterly commentary. In my opinion, in an attempt to avoid risk, many investors are running right into it. In my July 7 post I wrote, “Many investors were burnt last market cycle by piling into riskier cyclical businesses. When the 2008-2009 crash hit, many of these lower quality stocks were destroyed. Investors have learned their lesson this cycle, or have they? While high-quality businesses, such as utilities, have more certain cash flows and are less risky businesses, are they lower risk investments? Given current valuations, I do not believe they are.”

I’ve noticed more investors raising similar concerns – that lower risk businesses are not necessarily lower risk investments. That’s good news as I’m on the lookout for any shift in investor sentiment and psychology. Some high-quality stocks are even beginning to decline. Since my post two months ago, utility stocks are down approximately -4% on average. I know it doesn’t seem like much, but a decline of -4% feels like a crash in today’s market!

Based on the valuations of many high-quality stocks, I believe investors are demanding an insufficient required rate of return relative to risk assumed. In my opinion, depressed risk-free rates, along with the belief quality is a safe haven, are seducing investors into violating their valuation disciplines. In effect, historically low interest rates and the perceived safety of quality are providing investors with cover to pay exorbitant prices for mundane and low growth businesses.

In an environment with persistently low interest rates, many argue investors should lower their return requirements when discounting future cash flows. As stated in a previous post, if investors demand a lower rate of return due to lower risk-free rates, shouldn’t they also assume a lower growth rate? Aren’t risk-free rates depressed because of slow economic growth? The rate used to discount future free cash flows doesn’t exist in a vacuum. If return requirements have changed, what impacted the change, and shouldn’t that variable also influence other valuation assumptions? I think it should.

I’ve avoided constantly changing my required rate of return assumption as interest rates fluctuate. Instead of using artificially depressed risk-free rates as the foundation of my equity valuations, I use a discount rate that takes into consideration the risks of a business’s future free cash flows. I ask myself, “Given the risks of this business, what type of return on investment should I require?” If risks to cash flows haven’t changed, I don’t believe it’s appropriate to reduce return requirements.

The profit cycle is currently in decline. Several sectors such as retail, energy, and industrials, are providing clear examples that risks to cash flows remain alive and well. As the profit cycle reverts and risks to cash flows become more evident, investors are herding into high-quality stocks that appear risk-free. Considering the prices investors are paying for the perceived safety of quality, I believe it’s important to note that many high-quality businesses continue to possess operating risk.

Below are two examples of mature high-quality businesses that recently reported earnings or news that supports my view. Specifically, my belief that risks of high-quality businesses have not disappeared as many of their stock valuations suggest. Both companies are on my possible buy list.

The J.M. Smucker Company (SJM) is a good example of a mature high-quality business. Founded in 1897, J.M. Smucker manufactures and markets food and beverage products. Their three segments are U.S. Coffee, U.S. Consumer Foods, and U.S. Pet Foods. In addition to stable end markets, J.M. Smucker generates meaningful free cash flow and has mid-teens operating margins. There’s no question in my mind that it’s a high-quality business.

Similar to most stable high-quality businesses this cycle, J.M. Smucker has made acquisitions, bought back stock, and paid a dividend. As a result, net debt has grown from $626 million as of April 30, 2010 to $5.3 billion as of April 30, 2016 (I used fiscal 2010 as it includes a full year of its Folgers acquisition). Debt to equity has grown from 12% in fiscal 2010 to 77% in fiscal 2016. Finally, debt to EBITDA has grown from 0.7x in fiscal 2010 to 3.3x in in fiscal 2016.

While J.M. Smucker’s debt and debt ratios have increased considerably this cycle, the coupons on its debt have been cut in half to 1.75%-4.375% with maturities ranging from 2018 to 2045. In 2010 when it had significantly less debt, its debt was paying 4.78%-7.94% coupons. Visit almost any high-quality business’s balance sheet this cycle and you’ll find a similar pattern – higher debt levels with lower coupons.

In my opinion, the level of financial risk of most high-quality businesses, like J.M. Smucker, has increased since the end of the last cycle. This is a theme I’ve touched on recently and will touch on again in an upcoming post. In effect, corporate balance sheets on average are much more leveraged than the end of the last credit and market cycle. Financial risks are higher for most companies, even if interest rates on their debt have declined along with the risk premiums on their stocks.

While J.M. Smucker’s financial risk has increased, their operating risk remains below average given the stability of their end markets. However, as is the case with most high-quality companies, their business is not risk-free. J.M. Smucker’s recent quarterly earnings release illustrates this point.

On August 23, J.M. Smucker reported weaker than expected operating results and lowered its annual sales guidance. Comparable sales growth for the year is now expected to range from 0% to -1% down from 1% growth. Negative sales trends are partially due to weakness in its recently acquired pet food business (SJM paid $5.9 billion in cash and stock to buy Big Heart Brands in 2015). Sales in its pet foods segment declined -6%. On their conference call management noted, “For the Pet Food segment first-quarter sales performance was below our projection. We have revised our full-year outlook as we expect this softness to continue in the near-term.” Before its earnings release, J.M. Smucker was trading near 24x earnings (trailing 12-months) with a 3% long-term sales growth target. J.M. Smucker’s stock declined -8% after the earnings release.

Another mature high-quality business I follow, Core-Mark (CORE), released news last week that also suggests risks of high-quality businesses are not extinct. Core-Mark is a market leading distributor to convenience stores in North America. Core-Mark is a business I like and have previously owned. However, its stock is currently too expensive for me and suggests investors aren’t too concerned about risk.

After a string of contract wins, Core-Mark reminded us last week that contracts can also be lost. Specifically, the company reported the expiration of a supply agreement with Circle K effecting 1,100 stores. Even after declining 15% after the announcement, Core-Mark still trades over 30x earnings. While I like their business, I continue to believe investors are demanding insufficient returns relative to risk assumed and I’m avoiding their stock.

J.M. Smucker and Core-Mark are good examples of mature high-quality businesses. Both companies have valuations that suggested their operating and financial risks have declined meaningfully, when in fact they have not. In my opinion, investors are confusing low volatility — in business results and stock prices — with low investment risk. They are not the same.

I believe this cycle is filled with flimsy assumptions that are being used to justify inflated asset prices. I’ll continue to question these assumptions and provide specific bottom-up examples that challenge them.

Call Him Butter

Bill Gross is on a roll. In his outlook yesterday he made two very good points. First, he calls $11 trillion in negative yielding bonds, liabilities, not assets. It’s tough to argue with that. Using this same line of reasoning, why aren’t overvalued stocks also considered liabilities? When you overpay for a stock aren’t you actually committing to future losses, or booking a liability? Given valuations on stocks and yields on bonds, maybe it’s time to reconsider the name of the “asset” management industry.

In his outlook, Bill Gross also comments on the broken watch syndrome. Specifically investors who have been warning about the risk of this cycle are sometimes referred to as broken watches. He believes the watch isn’t stuck and continues to tick as global debt and policy harm economies. I agree with his second point as well. As I’ve written in the past posts, the central bank backstop is not perpetual. Once more investors, like Bill Gross, begin to believe their policies are harmful and counterproductive, psychology will change — set prices become unset and The Great Normalization begins.

As an investor who tends to be early, I’ve been called a broken watch or clock every market cycle. I usually respond by showing my historical positioning, which depending on my opportunity set, has fluctuated between aggressive and defensive. To avoid being a broken watch, I think it’s important to adjust positioning throughout a market cycle. Absolute return investors need to be and can be flexible — it’s one of our major advantages. Being a permabear or permabull is closed-minded. Permanently bearish positioning can carry tremendous opportunity cost. Conversely, shiny happy bulls can put significant capital at risk, especially near cycle peaks.

Positioning should adapt to your opportunity set. During each cycle there is usually a period of abundant opportunities when aggressive positioning makes sense. There are also periods when patience is the best option. The amount of risk assumed often fluctuates depending on where you are in the market cycle.

I like to think of the different stages of a market cycle as seasons. There’s a planting season (2009 large discounts/considerable opportunities), a growing season (2010-2011 justifiable multiple expansion), a harvest season (2012-2013 unjustifiable multiple expansion), and winter (2014-2016 extremely expensive valuations/maximum patience required).

Although it’s tempting, it’s important to avoid hibernating throughout the winter. Being patient doesn’t equal being inactive or lazy. During the winter season it’s a good time to sharpen your skills and gather sufficient seeds. You can’t take advantage of the planting season unless you’re prepared and positioned accordingly. The severity and duration of each season is unknowable so you must be ready. During long and harsh winters, like we’re in today, it feels like spring will never come. Thankfully it always does.