The cost of equity capital rose again last week according to Credit Trends comprehensive credit model. While free cash flow multiples are in the bottom half of its 40 year band, risk is in the top half.

Yield spreads, cash tax rate, adjusted operating cash flow and stability metrics rose by the greatest amounts while free cash flow caused a decrease. Additionally, the US 2-10 year Treasury yield curve spread, illustrated below, shows the risk of recession has increased.

Credit Trends reviews 70+ fundamental credit measures in computing its cost of equity capital.

For additional information on the model, you may pre-order “Security Valuation and Risk Analysis.” McGraw-Hill, available at all online book outlets. For the first time, the model will be released to the public.

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Summary
Much of the current stock market volatility is the result of security analyst poor understanding of risk. When security analysts appraise asset values, they discount the expected cash flows. Unfortunately, the rate they use is based on a measure of volatility (the beta) and not on fundamental measures, such as cash flow and credit strength. Because the cost of capital (this discount rate) has such as strong effect on fair value, it is resulting in unprecedented price swings.

Investors Need To Better Understand Risk

If it seems like200+ point swings in the Dow Industrials are a daily occurrence, it’s because it is. Over the past three months, in fact, the Dow has fluctuated in a 15% trading range and the S&P in a 16.5% range. The financial press, following the lead of investment strategists, has laid blame for these large price movements alternately on euro weakness, possible new legislation here in the U.S, trading restrictions in Germany, and various events in Greece, China, Turkey, Spain, and elsewhere. When blame is placed on alternating events, stock volatility is normally a result of other factors. The real culprit, I am certain, is investors, in general, do not have a proper understanding of security risk. That being the case, fear often engulfs analytical judgment as investors become unsure how to properly measure the expected returns along various asset classes.
When was the last time you heard a securities analyst or investment strategist remark? “Company X had an increase (or decrease) in risk during the quarter,” instead of they beat (or did not) earnings or sales estimates. Risk and reward cannot be solely judged by income statement results.
In truth, companies prosper for one reason: they can generate cash returns above their cost of capital. Simply put, that means the rate of return (measured by the free cash flow) on the assets of the enterprise are in excess of that demanded by creditors and equity holders. The greater and more consistent the margin between cost of capital and the return on invested capital, the safer the investment. Cost of capital, whether it is for equity, debt or hybrid securities are a true measure of risk.
Yet, today, security analysts are taught to gauge cost of capital by a measure of volatility, known as the beta coefficient, which is the security price change related to the change in an index, such as the S&P 500. It is a variable of what they were taught by academicians in business schools, as the capital asset pricing model (CAPM). This popular method of risk assessment is wrong, and is in good part, responsible for the current volatility we are seeing. Cost of capital can only be appropriately measured by the possible impairment to the free cash flows and its relationship to cost of capital. If an investor were certain as to an asset’s free cash flows, the determination of fair value would be considerably easier. But even with absolute certainly, fair value could not be made with perfect precision as economic circumstances change, such as the rate of inflation or tax rates. Those issues aside, a financial analyst should only be concerned with stock volatility if they, or the company they were following, were in the market to buy or sell securities. To the long-term holder, the cost of capital should not be determined by the swings in the stock price. The reliance on stock volatility in the placement of a cost of capital rate is so ingrained in Wall Street (sell-side) analyst research reports that it renders a high percentage of those reports useless. Security analysts are then forced to find an accounting yardstick such as price/earnings or price/book to back up their investment ratings. However, accounting ratios do not often reflect underlying financial risk, cash flows, competitive market position, possible loss of a patent or supplier, financial structure or resources available to the enterprise, which do in fact help determine cost of capital. Accounting concepts are often not a measure of cash that could be used to repay debt or distribute wealth to shareholders.
One never hears of successful builders of businesses mention beta, or other academic statistical risk tools. They talk about products, customers, risk and cash. They talk about growth rates in free cash flow, taxes, and stability. Consider the following, and ask if beta or fundamentals should drive their stock prices:
Georgia Gulf has a beta of just 0.3, indicative of a low risk entity, yet it is rated just “B” by Standard & Poor’s (S&P). A “B” rating by S&P is defined as, among other things, as having greater vulnerability to default than other speculative grade debt that could lead to inadequate capacity or meet timely interest and principal payments.

Comcast is rated BBB (“adverse economic conditions could lead to default”), yet analysts may consider it to have a lower cost of equity capital than 3M, due to its having less stock volatility as reflected by its beta coefficient. A “BBB” rating is regarded by S&P as having predominantly speculative characteristics. 3M is rated AA-, which S&P indicates as having a very strong capacity to repay interest and principal.

Hundreds of companies have low betas, and are thusly accorded a low cost of equity capital- yet they can’t pay their bills! Hundreds of other firms are erroneously accorded a high cost of capital, yet are strong and consistent producers of cash flow and do so with just moderate financial leverage. True, many hundreds of companies are in bankruptcy, technical default or a stiff wind away from that status, yet have a lower cost of capital, because of their stock trading patterns, than say, a Microsoft, or other deserved AAA rated entity.
Cost of equity as calculated via the misty lens of stock volatility has been followed by consultants who received their M.B. A.’s at university’s teaching this faulty gospel. These leading management consultants, in turn, have advised Board of Directors these methodologies are the most appropriate approaches, and since they are taught at leading universities, have not been questioned.
Companies with unpredictable sales, volatile tax rates, upcoming litigation, are not producing positive cash flows, have recently undergone a large business combination, risky foreign exposure, are but a few of the metrics analysts must look at to determine cost of capital, hence risk. Stock swings may not be associated with such factors.
The following table illustrates the difference to cost of equity capital when based on a the credit model employed at CT Capital versus that used by Wall Street analysts basing risk off of the capital asset pricing model. Given a 1% change in the cost of equity can change fair value by a third, it is no wonder stocks are as volatile as they currently are.

Company                    CAPM     Credit Model
Toyota                             7.5%        9.7%
Rite Aid                         6.8%       18.5%
IBM                               10.0%         8.4%

Unless then, investors begin to adopt more suitable risk metrics based on what is important to owners of capital- their ability to earn a cash based return in excess of cost of capital using fundamental metrics, and not stock volatility, the latter often the result of fear, greed, institutional trading or rumor, expect stocks to continue to show aggressive trading swings, the kind that tend to scare most small investors away from the stock market.

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The release from Reuters of a dramatic fall-off in IPO’s and re financings is a negative for cost of capital.

Although deals are being done, the drop effects most companies given the widening of credit spreads. Most net borrowing entities have significantly strengthened their balance sheets over the past year and a quarter, although they are continually dependent on debt and equity markets. Such firms remain especially vulnerable

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Cost of equity capital has risen for three months in a row, almost on weekly basis. And this week, cost of equity, for the S&P 500 companies, has risen to over 9%, the first time it has crossed this mark in over a year.

What has been the reason for the increase?

According to the CT Capital credit model, and outlined in my upcoming text, “Security Valuation and Risk Analysis,” McGraw-Hill, rise in yield spreads, sovereign risk, cash versus the effective rate, and volatility measures of several fundamental metrics, have led the way.

But they are not the only metrics which pinpoint increases in fundamental security risk.

Most have to do with credit health, such as rollover risk and the ability to repay all debt from a consistent cash flow stream when those cash flows are adjusted to normalized conditions. For example, while cash flow from operating activities and free cash flow have been increasing, when adjusting for normalized levels compared to sales and balance sheet, the rise is subpar, especially when taking into account spending plans.

Most entities which have announced large rises in cash flows plan to have such resources consumed thru additional spending agendas, which are not necessary, given their current sales level. The lessons they have learned from the financial crisis have not sticked. Other enterprises are once again buying back their stock, which, in our opinion, is almost always a waste of corporate assets.

Other credit measures are generally in line with normal conditions, although for certain firms,  cost of capital is indicating a risk to cash flows not currently assumed. Many firms, for example, will see large amounts of cash needed to fund both domestic and foreign benefit plans.

With the multiple on the S&P now suggesting stocks are near fair value ( 2% over-valued), the rise to cost of capital needs to be better understood.

Kenneth S.Hackel, C.F.A

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The 3.5% decline in the S&P has now brought the index to approximate fair value, given our expectation of 4% annual growth in free cash flow over the coming five years and a 8.1% cost of equity capital. The last time we wrote this was the case, the S&P rallied 15% over the coming 3 months.

Although the cost of capital has risen over the past month, the decline in valuations, to 17.8x FCF, has resulted in a fair valuation. Although many firms are reporting impressive growth in operating cash flow, we are finding much of this cash is to be consumed in newfound growth initiatives. We would avoid these entities, and would continue to concentrate on firms which have shown continual improvements in their cost structure.

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We have noticed a very broad trend on the part of firms which have, over the past three quarters, shown good growth in free cash flow, especially when associated with moderate top line growth, to begin to pick-up their cost structure.

New growth initiatives, share buy-backs, and increases in SG&A, do not bode well for free cash flow later in the year. If this expected growth does not materialize, the stocks of these companies would give back much of the gains seen over the past year and a half.

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Lower interest rates on the ten-year Treasury (risk-free rate) do not always lead to a lower cost of capital. This was clearly seen during 2008 as interest rates fell yet cost of capital rose, as credits weakened due to the effects of the recession and illiquid credit markets. Conversely, higher rates may not always lead to higher cost of capital, as particular industries benefit from (the fear of) inflation and price increases relative to costs. Where the yield spread and risk-free rate do not capture inflation on the security level,  we adjust cost of capital.
Contrary to popular thinking, a rise in inflation cannot be overcome by a similar rise in revenues-it must be overcome by a similar rise in free cash flows, or cost of capital will increase. Also to be taken into account is the effect of inflation on capital to be replaced. If the cost of such capital has increased at a rate greater than the increase in free cash flows, this metric would result in a greater penalty.
The inflation rate affects economic and business risk, including the value of balance sheet inventory, which may be severely understated for firms using LIFO accounting. And, as history has shown (see Illustration), the impact of inflation is not always accurately divined in the risk free rate, which is used as the beginning building block for the cost of equity capital model. Also, the inflation rate and the expected rate of inflation affect firms differently, and thus this metric may need to be adjusted for those groups. Those enterprises with high leverage, sensitive to commodity price swings, or those enterprises that own significant investments whose values are tied (directly or indirectly) to the level of interest rates, will be more greatly affected by changes in the expected rate of inflation than those entities which can pass along its consequences, such as some utilities.

Risk Free Rate

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We have received a number of emails regarding our perception of the increase in risk overwhelming the rise in free cash flow.

There are many factors which contribute to credit risk, with Sovereign debt and foreign exposure being just two. Please do not forget the rise we are seeing in free cash flow is made possible, in good measure, from cost cutting, to the extent when we adjust for normalized changes in working capital, the increase, while, positive, loses about 40% of its magnitude.

This is not unusual for the initial stage coming out of recession, but must be compared to the very large rise, over the same period, in valuation multiples.

Additionally, our credit metrics, especially our consistency measures, have increased over the past month, while other measures, such as health care, taxes ( not just federal income), and foreign pension burden, have all been rising.

All in all, the S&P is about 5% over-valued. Typically, as stocks can fluctuate wildly around fair value, a 5% over-valuation is within normal range-and can even result in a rally. If that were to occur, we would recommend, as we have been, to sell into such rally.

There are, however, stocks that are as much as 40% undervalued, based on free cash flow growth and valuation, cash based ROIC compared to a credit-based cost of capital, and financial flexibility, and it is there where we continue to focus.

For additional information, contact either myself or Simon Adams

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Unlike research and development (R&D), which, as we pointed out yesterday, has not seen severe budget cuts, the same cannot be said for capital expenditure budgets.
Although, for all S&P 500 companies, capital spending has rebounded from the Sept 2009 quarter, given lethargic top line and employment growth, we believe any quick snapback in capital spending is unlikely.

As the largest stock returns evolve from a turn of events, not a continuation of one, we are recommending investors (as we have) reduce their exposure to those effected sectors, and overweight sectors with ties to productivity improvements, low cost of capital and high ROIC.

For additional information call Kenneth Hackel, C.F.A. or Simon Adams

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For all S&P reporting companies through May 12, 2010, the median entity has surprisingly maintained its R&D budget.
For the latest reporting quarter, the median S&P firm spent 4.9% of total sales on R&D, compared to the March 2005 quarter of 4.2%. This is up from March 2009 quarter of 3.9%. Total estimated spending on R&D over this period rose quarterly from $34 bn. to $39.4 bn. These numbers are approximate as not all companies report R&D each quarter, as picked up by S&P Compustat services.

The data in the chart is fairly accurate as when we look at annual data for all S&P reporting companies, total R&D expenditures rose from $ 121.4 bn. to $164.7 bn.
CT Capital looks at research spending in relation to revenues, unit growth, cash flows and cost of sales when analyzing free cash flow. A percentage of any overspending in R&D is added to free cash flow. Over the past year, enterprises have, in general, been judicious in their R&P spending as they have in managing their other corporate assets. They continue to be optimistic regarding the potential of their R&D spending.

Reporting firms’ R&D (as opposed to capital spending budgets), have, in general, been maintained within historical standards.

Kenneth Hackel, C.F.A.

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According to today’s Wall Street Journal, Lloyd Blankfein, Goldman Sachs’ chairman, would like the firm’s clients to know it will be an ethical leader.

That will, as an inspection of their trading reveals, be quite difficult, unless they do away with their proprietary trading desk. For as long as the firm continues to trade billions of dollars a day for its own account, it will be placing, at times, large bets against its clients.

Unfortunately, its trading desk is too profitable to relinquish voluntarily- at least without a fight. But how does it fight to keep it, given the spate of anti-Goldman sentiment, with its only real beneficiaries being its employees and shareholders? It serves no greater economic or financial good. To the extent the trading desk can manipulate, with its billions of dollars in capital (no figures are released), financial markets in the direction it is betting, its clients’ interests are not just served-they could very well be hurt.

This represents a diametrically opposite picture given by its chairman before the Senate committee last week, in which he gave the impression its trading activities, were incidental to that of its clients. It is apparent that the prop desk represents a very large percentage of its revenues, profits, and cash flow, although it is difficult to precisely determine, especially given the firm’s large interest income, and the extent to which interest results directly or indirectly from the trading desk.

But Goldman will obviously not give up its prop desk unless it is forced to. As the table shows, of its $45.2 bn. in firm revenues, it received 76% from trading; interest income and trading provided 95% of total firm revenue. Of operating profits, 87% came from trading. Included in its trading operations are trading in the most speculative of derivatives, the kind which a slight information edge can result in $1 bn. profit within weeks. Goldman controls over half of the principal program trading on the NYSE. It would be noteworthy to find out the extent to which its short and derivatives portfolio were active bets-not hedges-against clients, and if they solicited such trading so that they could make such active bets. It would be of interest to know how much capital Goldman has, on average, throughout the past years, committed to its prop desk.

One thing is for certain. If Goldman is forced to give up proprietary trading for its own account, or under the careful eye of government regulators must cut back such trading, Goldman Sachs’ franchise value will suffer irreparable harm.

To what extent could we see Goldman Sachs stock drop? To get a clearer picture of the effect of its trading prowess, I looked back 10 years and evaluated the growth in trading had on cash flow and net income. Given Goldman’s last fiscal year $13.4 bn. in net income prior to preferred dividends, I estimate 30% resulted from proprietary trading of its own accounts, or about $4 bn. Given net income of $9 bn., and 526.2 MM shares outstanding, we would still looking at roughly $17 per share, if a cutback were in order. On the other hand, if the firm returns to the wild pre- derivatives era of 2000-2005, when Goldman earned, on average about $6.50 per share, as trading revenue were considerable less than half current levels, but was still very profitable, that absent prop trading, net income could easily be reduced back to the $6.50 per share level. If that were the case, Goldman’s stock would be expected to fall to the $70s, especially given slow economic growth, which would be offset by their high market share given competitor weakness both in the US and Europe.

The most reasonable scenario is some cutback in prop trading, the extent of which cannot be determined or even reasonably estimated. But at its current levels, there appears to be too much risk in the shares of Goldman, despite current strong cash flows and a low valuation multiple. If however, Goldman is able to carry out its business with essentially no change to its prop desk or other businesses, a low probability scenario, I would expect to see a large rally in its shares to the $200 level. For shareholders, the fate of the firm is in the hands of the Congress. And that’s not a risk worth taking.

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