The almost 4% recent decline in the S&P 500 from the close of November 5 (recent peak) thru today could not come at a worse time for firms with underfunded pension plans. The median assumed long-term investment performance, for most firms, is now below the 8% median for the year, and noticeably below for the past 5 and 10 year periods. While the median discount rate assumption, of 5.9%, has seen some minor relief, it is still providing pressure, given the fall in yields during 2010. The discount rate assumption compares with a current 2.77% 10 year treasury rate while annuities hover around 3.8%. Firms may also elect to partially close out its plan thru annuitizing a segment of its population.
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The past few years out-sized swings in the prices of financial securities have been caused, no doubt, by changes to credit and risk, which form the basis of the cost of equity capital. Yet, despite security analyst and investors continued fixation on the quarter up the road’s reported earnings, it is evident it is the ability to create value ( through enhancement of free cash flows) and reduction in cost of capital that should stand front and center for investors looking to enhance their portfolio returns.
“… to help, or at least do no harm.” Hippocrates
“… to help, or at least do no harm.”
Hippocrates
Investors, without recognizing the implications of their decisions, often sway from the fundamental concept of doing their portfolio no harm.
What began as a study on sovereign risk (an important element in CT Capital LLC’s cost of capital model) turned in some interesting offshoots. The study was also undertaken because the CT Capital, equity portfolio has a larger than normal (14%) exposure to ADRs and we wanted to uncover the reason(s).
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Readers will come to understand stock movements they currently have trouble explaining, since significant movements are almost always led by changes in cost of equity capital and the perceived risk to the credit (cash flows). The text explains why entities having a low cash-defined ROIC resulting in small amounts of distributable cash flows are accorded lower valuations despite having higher rates of growth in revenues and/or earnings.
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(The comment below does not constitute an opinion as to the valuation of Honeywell (HON) common stock—only its pension accounting.)
However, for investors who make buy/sell decisions on the basis of P/Es or other accounting conventions, the news out of Honeywell was certainly good. For 2011, the firm, based on information released yesterday, expects to accrue a $200MM expense on its P&L, despite an actual cash contribution into its pension plans of $1 billion. Its shift to mark-to-market helps during periods of rising asset values.
Honeywell (HON) announced a change to its method of pension accounting whereby it will reflect changes in market value each year instead of the smoothing them, which helped show a healthier plan when market values were declining for Honeywell. Now that market values are rising, Honeywell is desirous of changing its methodology. The company then revised its earlier results in conformity with the changes.
Taxes are an important focal point of securities analysis due to its scope, size, as well as its direct and measurable impact on cash flows. Taxes impair current and prospective operating cash flows because it is imposed on residual profits, after a series of adjustments and credits; the only question is the degree. Investment projects are always considered on an after-tax basis, considering both the income tax effect and the financing effect. Special tax incentives may also impact the hurdle rate and project return on invested capital (ROIC).
Because taxes are not imposed on its income an enterprise pays as interest to creditors, the income tax system creates a bias in favor of debt financing. This bias often results in the overuse of leverage by some firms, and a greater probability of bankruptcy.
When Kraft (KFT) released its balance sheet and income statement when reporting its fiscal third quarter last Thursday, it did so without a corresponding statement of cash flows. In its place, including during the ensuing conference call, Chairman Rosenfeld redundantly pointed to operating earnings without a single mention of cash flow, unusual given the heavy reliance by investors on the dividend. Operating earnings do not represent distributable cash flows, among other reasons, it is reported prior to interest expense, which is hefty for Kraft.
UPS sold $2 billion in long-term bonds to fund its pensions yesterday, raising its total debt/equity to over 100%.
Although UPS is a solid and consistent generator of both free and operating cash flows, we saw that during the credit crisis of a short couple of years ago, even UPS’s fixed income securities could be impaired.
If equity markets represent the flawless leading economic indicator generally believed, investors should be very comfortable nowadays. After all, the S&P 500 is up almost 12% so far this year. Yet, economists remain generally concerned.
Is it not then unreasonable to ask: Are the glorious headlines trumpeting rising free cash flows portending a sustainable and durable continuation of the economic expansion or perhaps the result of severe cost cutting with a dose of imaginative accounting?
A revolutionary new alternative to traditional discounted cash flow valuation models!
