Archive for June, 2011

A Sensible Definition of a “Bear” Market

June 19th, 2011

A bear market is generally defined as a decline in a widely followed stock index, such as the Dow Jones Industrials or the S&P 500 index, over a greater than 2 month period, by 20% or greater from its most recent high price.

This definition, however, ignores the important valuation component, and as such, must be viewed as faulty, simplistic and perhaps even naive.

For example, a share of stock which previously sold at a hundred times free cash flow, meaning its owners can expect to receive no greater than a 1% return on their investment, declining in value so it now sells at 80 times its free cash flow ( or 1.25% yield), would meet the simple, but generally accepted bear market hurdle.

But should this firm now yielding 1.25% (or less, if it doesn’t generate free cash at all), be considered to be in bear market territory merely because its stock now reflects reality rather than a previously exaggerated valuation.

All we need to do is take a look at the late 1990’s, when technology stocks frequently sold at greater than 100 times their revenues, to say nothing about the return investors could expect .

Bringing it down to the individual security level, you might recall JDS Uniphase, which during that time sold at over $1100 a share, split adjusted.  Could one rationally posit when its stock fell to $880, it placed the security in “cheap” territory,” or more realistically, simply less ridiculous? When viewed this way it is obvious one should look toward valuation aside from drop in value. If so, JDSU would not have reached bear market territory until it dropped to below $10 per share, given it produced negligible amounts of free cash flow during 1997-1999.

Common sense would mandate market pundits should consider not only a fall in the price of a security but also whether the prior valuation made sense in the first place. While we all like simplicity, the connotation of a bear market is the value of an asset has dropped to an unfairly low level given undue pessimism. But if the current valuation level were indeed somewhat fair, one should hardly consider the price to be that of a bear market value.

Implicit in my thinking is there is a fair and reasonable judgment as to fair value, and one which I am comfortable offering a solution, which is as follows:

A bear market occurs when the value of a large grouping  of equity securities, believed to be reflective of the general economy both falls in value by 15% and has a free cash flow yield of twice that of the 10 year treasury yield, based on the firms normalized free cash flows.

Using this definition, the last bear market would have been declared on February 6, 2008, not June 27, or almost 5 months sooner than recognized. This could have allowed congress and the treasury to perhaps save many tens of thousands of jobs, and investors and creditors much grief.

The exception to my 2x treasury yield definition would be during periods of hyper inflation, during which time less than a doubling would be necessitated to trigger a bear market; a sliding  scale that would work its way from 2x up until a 10% yield to just 10% greater should the treasury yield approach 15%. Thankfully, in the U.S. at least, such instances are extremely rare, having been there just once.   As seen in the following 130 year chart, the only period when 10 year yields pushed over 5% resulted from the oil embargos impact on the general price level and wages. Thus, a required 10% free cash flow yield would likewise be rare.

While many would suppose the distinction between the suggested and generally accepted definitions are inconsequential, it is not borne in reality.  And for stock market historians, investment strategists, investors, and yes, politicians, the need to know if a bear market exists is important in everything from asset allocation to policy.

So, given my suggested definition, where would the S&P 500 need to fall to enter bear market territory, and how would that differ from the generally accepted definition?

The S&P 500 began its current bull market in March 2009 and reached its most recent closing high on May 2 at 1361.22. A 20% decline would therefore take that index to bear market territory at 1088.97, or a little over 14% from yesterday’s close of 1267.64. Stocks dropping to that level would, in my estimation, be well into, not at the cusp of, a bear market.

Ten year treasuries currently yield 2.93%. The S&P 500 currently has a normalized free cash flow yield of 5.22% ( or a 19.15 multiple), which includes both corporate overspending and misclassification errors, such as taxes, payments to non-controlling interests, payments on guarantees, factoring, underfunding pension, and the like.  If the free cash flow yield on the S&P 500 were to provide a return twice that of treasuries, stocks would need to yield 5.86% or treasury yields would need to fall. Stocks would therefore need to decline another 10.9%, given their current free cash flow yield and the requirement to permeate the 15% barrier. This combination is considerably smaller than today’s thinking would have it, as generally recognized by the simple 20% definition, and is due to the spread between the treasury rate and the free cash flow yield. In other instances, the barrier might be considerably larger or smaller than the naive bear market definition.

Intuitively, I believe most investors would agree another almost 11% fall in the general level of equity prices would constitute a bear market, not 30% greater than that. And in this case, their perception would be correct, as would be borne out from the fundamental underpinning of equity investing-a firm is worth the present value of its free cash flows. In conjunction with a severe drop in stock values, these two metrics form the basis.


Kenneth S. Hackel, CFA


To learn in-depth cash flow analysis and risk (cost of capital), please see Security Valuation and Risk Analysis

Corporate Cash….All that Glitters

June 7th, 2011

All that Glitters……..


A recent report out of McKinsey in Co.(McKinsey Quarterly, May 2011) stated European and U.S. companies hold excess cash on the order of $2 trillion. The general point of the article is how companies’ should begin paying back its shareholders given the large excess funds they both hold and will continue to produce.

I find McKinsey’s arguments to be both an exaggeration and misleading for the following reasons:

1- The cash does not account for funds held in geographies which, if pulled would result in a large tax, in perhaps two countries. In fact, certain countries would not permit such payments at all.

2- It does not account for needed working capital

3-It does not account for debt due

4- It does not take into account funds needed for expansion, or business combinations, R&D, or additional hiring.

5- The desire to hold excess cash may be needed for other obligations, such as pensions, employee buyouts due to restructuring, commitments, or guarantees, both legal and moral.

6- The authors do not explain why firms must distribute cash back at all, even if several years have passed awaiting opportunities. Capital gains has always proved the better after-tax reward.

7-The authors defined excess cash as the amount of cash outstanding over and above operating cash, which is defined at 2 percent of revenue. This is clearly a poor definition of excess cash.


What the article does correctly point out, however, is the net effect on the firm value of share repurchases is zero. This is a subject I have long ago pointed out. Share buybacks improve accounting metrics, but do nothing to improve ROIC.


My point is the amount of excess cash is not nearly that amount claimed. I strongly believe a secondary reason for the US economy and stock market free-fall just a few short years ago were the massive buy-backs, which, by eating up capital, only served to deepen the credit crisis while driving some pretty large institutions out of business. I believe shareholders would have earned greater than 3% over the past five years had companies acted more prudently, and invested in assets and projects earning a safe spread between ROIC and cost of capital than depleting cash and equity.


Buybacks have not proved to be a “reward” to shareholders, as managers and too many investors and stock analysts, claim the programs to be.


For more information on this subject, contact Kenneth Hackel or consult “Security Valuation and Risk Analysis.”


Change To Risk Free Rate Security to Have Profound and Immediate Impact on Valuations

June 6th, 2011


The most implicit building block of security and company valuation is use of the risk free rate.

Whether undergoing a fairness opinion, a discounted cash flow model, or any number of other on-going concern valuation estimates, the starting point is the rate attainable with an investment in a risk-free security. It is the initial yield from which other elements of risk are added to arrive at the cost of equity capital. Simply stated, the higher (lower) the cost of equity, the lower (higher) the fair price investors would be willing to pay, given a set level of free cash flows.

Since the formulation of the capital asset pricing model, the risk free rate used has been the US government bond.

At CT Capital LLC, we use the 10 year Treasury bond, as that security best matches long-term asset programs, whether they be the building of a factory or a merger partner, from which a return on that invested capital is demanded.

Of late, as talk has gathered momentum, led by House Majority leader Eric Cantor, that politicians are willing to allow the U.S. to default on its obligations, analysts must now carefully appraise whether a defaulted security is, in the truest sense, a risk-free instrument.

One must conclude, even if a limited duration default were to occur, the answer would be no, and would be even more undeniable if seconded by a downgrade by a major credit rating agency, as Moody’s has threatened last week. Standard & Poor’s also downgraded its outlook for the U.S., citing “very large budget deficits and rising indebtedness…”

For this reason, should the U.S. Congress not come to its senses, CT Capital LLC will, if, due to QE2 or other Fed intervention, the 10 year Treasury bond not reflect economic reality, utilize an additional penalty being the cost of a credit default swap, currently 53 basis points. Thus, a current risk-free rate 10 year Treasury bond yielding 3% would in effect be raised to a 3.53% risk free rate.

Another alternative would be utilizing the 10 year rate on a liquid AAA corporates, currently 3.42%. However, even a basket of the cash instruments could present liquidity constraints and thus may not, for the time being, present a realistic alternative compared to the $9.7 trillion of U.S. debt in the hands of the public.

The brunt of a raise in the risk free rate is to force lower valuation multiples for the equity market in general, as would always be the case when the cost of capital rises. Investors demand a higher return for committing their risk-based capital as prospective free cash flows are attached to greater uncertainty reflective of the new higher rate.

Even if U.S. Government securities were to escape a default and credit downgrade in August, the tea leaves indicate it remains a matter of time before that inevitability occurs.


And when that time comes, investors, company stock analysts, and buyers and sellers of businesses, would feel a swift and powerful jolt to their reward expectations, as pronounced by the cost of equity beginning with that new risk free rate of interest.  And they will act and invest accordingly.




Kenneth S. Hackel, CFA


Google Inc. -Security Analysts and Many Investors Show Their Mettle-Tin!

June 2nd, 2011

Tin, while not ranking as high as mercury, is still a weak metal. And many investors continue to exhibit its malleability, over-reacting to a single quarter’s financial results, even for firms which have growing cash flows, have added value during the quarter, and possess strong financial structure and flexibility.

Investors must understand that firms do not operate with the smoothness of a well-crafted tool. They are not machines- yet enterprises that are well managed will continue to build value, even during periods when planning, rather than providing actual results, take place. For example, smart managers acquire during recessions, and aren’t afraid to do so, a time when weak firms are forced to sell assets.

This leads me to Google.

Google disappointed investors during its first quarter due to a perceived lack of financial discipline, as operating expenses rose over twice as fast as its 27% revenue growth; the company hired over 1900 new employees, handed out large salary raises while boosting other discretionary expenses, especially marketing. While GAAP based income disappointed, normalized free cash flow growth clearly exceeded our model’s metrics. Revenues represent a lofty model weighting as discretionary expenses can typically be controlled, while product acceptance reflects the quality of and demand for the product or service. This is not to downplay expense control, as efficiencies including improvements to supply chain and other direct expenditures have the same effect as boosting cash flows and hence, market valuation. Clearly, Google’s products are being very well received in the marketplace with collections from customer receivables growing at a near 24% rate.

With Google selling at 6.1% yield on enterprise value, we view its stock quite appealing, and can point to any number of lower quality companies selling at considerably higher valuations. Although Google shares are currently fair valued at $604 a share, that estimate would jump if managers keep expenses and margins in line and revenues grow as expected.

Obviously, if Google needs to continue to write $500MM checks to settle lawsuits, its fair value will fall and cost of capital will rise. However, its very strong and predictable near-term free cash flows can fight off these legal issues assuming they can indeed be put to an an end. Given the sensitivity analysis below, using our free cash flow model (please refer to Security Valuation and Risk Analysis), current fair value for Google is sufficiently above its current price. The 18.5% tax on repatriation represents the company’s five year average cash tax rate, based on Google’s net cash of $32 billion.


Google Fair Value Sensitivity Using CT Capital Free Cash Flow Model

Disc Rte. Probability FV

7% 10% $732.04

8% 10% $642.04

8.25% 10% $621.91

8.50% 15% $602.64

8.75% 20% $584.18

9.00% 20% $566.49

10.00% 15% $502.76



Fair Value Cash Flow 100% $595.54

Net Cash/Debt* 8.1

Fair Value Per Share $603.64

*includes tax on repatriation and working capital



Note: Google shares are held by clients of CT Capital LLC.