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.