Archive for September, 2011

Buffett Sending Wrong Message

September 26th, 2011


If Warren Buffett wanted to send a message that stocks, including that of Berkshire Hathaway, were undervalued, he should have announced a series of acquisitions across a spectrum of industries.

By doing that he could have both improved the lot of Berkshire shareholders by improving its return on capital, free cash flow and financial structure, and that of consumer and investor confidence, in general.

Through announcing the possibility of large share repurchases, he is doing the opposite. Giving cash to shareholders who want out the door does not create a penny of cash flow,  cost of capital or the spread between the two, although it does aid GAAP based metrics. Although Berkshire does not grant stock options to executive officers, many firms do indeed benefit from improvements to GAAP as it is used in many plans determination of compensation.

Berkshire, despite the large cash hoard appearing on its balance sheet, needs to preserve cash. To begin, it does have $59 billion in debt. In addition, it has liabilities to insured’s, both present and to come, especially as management does take risk which many competitors do not. Also, Berkshire has $35 billion in notional value in put contracts ( a bullish market play) which increased by $1.2 billion thru June 30th, and is obviously quite a bit higher today given the downfall in stocks since.  Although these a are long term contracts, the liability is real and could be significant, not something credit rating agencies like to see. Nor do they like to see depleting equity, which is the direct result of share buybacks.

I believe, the announcement out of Omaha today is more a reflection of Mr. Buffet’s age then an endorsement of share buybacks. Is there any doubt Berkshire has built value through capital acquisition and resultant free cash flows, rather than share repurchases?  Investors have bought stock in the company over the years due to Buffett’s keen analytical ability in building capital-share buybacks destroy it.  In fact, if other firms were to follow suit, given the economic slowdown, many would find themselves in a position similar to 2008.


Expect Ratings Downgrades To These Companies

September 9th, 2011

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Why Equity Prices Are So Volatile

September 9th, 2011


With long-term investors approaching the state of greeting 300 point swings in the Dow Jones Industrial Average with a yawn, some might begin to wonder. When the immense swings persist, yet the speculated causes remain constant, investors should quit wondering and begin looking for more useful investment tools.

Indeed, stock prices around the world have, over the most recent period, undergone historically large daily changes in their market values. During this period, investors have been fed a journalistic diet of pablum, for lack of a more substantive intake out of the ken of mainstream security analysts. However, as even a casual observer of the financial markets can attest, these unvarying causes have rotated with the velocity, without the entertainment value, of a circus juggler.

A European or U.S. banking problem one day, an economic slowdown the next, with an occasional terrorist threat or sovereign budget flare-up, have, for some period of time now, all been reported as reasons behind these 2%-3% seemingly daily swings in the equity markets.

But think about it.

The fact the same issues keep resurfacing and are met by large market reactions (regardless of direction) implies investors have not properly evaluated-or perhaps even taken into account- known risk-for if they had done so, worldwide equity markets would be countering with greater calm as these headlines repeat.

A properly set cost of equity capital, in which investors account for all possible risks (along with their probability) to the prospective free cash flows- results in fair value remaining essentially unchanged should any such event unfold. If the probability of the event remains unchanged, the impact on fair value is nil.

The cost of capital will remain constant until there is absolute reason for the analyst to believe the risk landscape has been altered.  In fact, cost of capital tends to remain in a very tight band for most companies throughout an economic cycle.  As one cannot say the leading financial news items making the rounds today has changed much over the past quarter, I strongly argue, the recent abnormality in stock price volatility is not just unwarranted, but indicates a fundamental lacking of basic investment principles and application by professional security analysts and investors.

In reality, only new and material information should result in large swings to the prices of financial assets. Everything else is just “noise.”

A central reason, unfortunately, for the recent volatility is investment analyst models in wide practice today do not accord risk on a similar footing with earnings, or, more correctly, free cash flows.

The setting of the cost of equity capital must account for any known risk to a firm’s free cash flows. This forms the denominator of the net present value model. For example, in BP’s 2009 10-K, the company stated they self-insure the risks related to their offshore rig exploration. Yet, almost investors chose to ignore the possibilities, looking at self-insurance as an incremental boost to earnings, not the other side of the coin, risk.

With a proper cost of equity, portfolio turnover will be greatly reduced, as investors will not feel the need or the requirement to re-process information which is already reflected in their estimate of fair price.

Thus, if the stock market were to rise (fall) by 3% tomorrow, because of somber news from Greece or a weak European bank, then you can be sure investors have either not done their homework, or are over-reacting to news implicit in market values. As the kids say, “Tell me something I don’t know.”

Assuming a firm, XYZ Copper, which, despite a cyclical history of normalized positive growth rate in free cash flow is nonetheless exposed to volatile demand (revenues), input costs, and has its chief mine in what many consider to be a country with a government that, at times, has expressed hostility towards the U.S., and, in fact, whose workforce has struck the mine three times in the past decade, although no strike lasted more than 45 days. Assume there is no threat of nationalization.  XYZ’s financial structure is also slightly leveraged, resulting in interest costs as a percentage of normalized and adjusted operating cash flows slightly above average. Whereas the S&P Industrials, itself a high quality group of companies, has an 8.2% cost of equity, we have determined that XYZ Copper has a cost of equity of 9.5%. Thus, the cost of equity takes into account these known potential risks as well as perhaps other risks not discussed here.

Analysts expect XYZ, which has $ 3.93 in net balance sheet cash to generate $ 3.13 in free cash flow during the current year. Due to the economic slowdown, its free cash flows are expected to fall by 20% for the following year, and then to grow 2.5 % per year over the coming 22 years, at which time the company will be sold or can be expected to have a market value at its historic average 10x free cash flow multiple. Fair value, including the net cash, may be approximated using by its net present value, at $34.00.

If XYZ were dealt a wildcat strike (new material information), what would be the impact to its fair value? To begin, its cost of capital, unless there was concrete evidence to believe otherwise, should remain the same. Strikes have been built into our risk to cash flows.  As the firm has been in existence for many years, even if the company had cash payments to be satisfied, they would have already lined up adequate credit facilities in addition to the existing cash[1]. The only change in the fair value model would be the decline in the current year’s free cash flows, which instead of$3.13, we cut by 6%, to $2.94, to account for 45 days of free cash flow of which half is recouped, a conservative assumption given firms usually have inventory for such a possibility. Fair value drops to $32.31 or just a 5% difference. If the investor believed the strike was a possibility in year five, current fair value would fall by just 50 cents per share-such is the nature and importance of the discount rate, or cost of capital. It deals with these known risks.

My point: the same logic can and should be applied on the macro level. Make the adjustment to cost of capital as is required, so when the same scary headlines bounce back, you needn’t make any further calibration, other than perhaps the TV station that keeps giving you the chills.  Only new information is of relevance and would impact the fair value estimate.


Kenneth S. Hackel, CFA

[1] In practicality, firms would also take other measures to boost cash flows, such as “work” the balance sheet and cut discretionary expenditures.


Pension Funds-Analysts Need to Immediately Make Adjustments to Cash Flow and Financial Structure

September 5th, 2011


Pension funds, which benefitted last year, when the financial markets underwent a strong second half rally, may not be so fortunate this year.

And while a headline in today’s Financial Times reported the gap in US pension plans was $388 billion, CT Capital LLC reports the gap is considerably higher, perhaps by as much as 50% when using interest rates available today and the fall in hedged fund returns, which many pension sponsors have been viewing  as “high return, low risk.” They have taken the same tact with private equity investments.

In fact, we expect to see a considerable step up in pension contributions later in their year, including selling equity and debt, as well as the contribution of company stock, where allowable.

For the 1400+ public companies we track which have defined benefit plans, the median investment return assumption is currently 7.75% (average 7.36%), a discount rate of  5.4%, and has a 57% exposure to the equity markets, 37% debt markets, and the balance real estate and hedged funds.

The average company reported their plan was $376MM underfunded, but that assumes their assumptions are realistic. The current financial markets tell us otherwise.

For some firms, including Boeing, GM and IBM, the underfunding is in excess of $10 billion each.

This means these firms financial leverage is greater than reported and their cash flows (from operating activities and free) are overstated.

The list of firms in pension trouble is not restricted to U.S. based entities. For example, Allianz SE, BP, Daimler, Deutsche Telecom, Siemens, Toyota, and Volkswagen have huge pension liabilities that must be addressed.

The defense sector is especially prone to large pension liabilities, unfortunate given the slowdown in the defense budget.

And for the many firms like Honeywell, which changed their actuarial methodology from asset smoothing (outside the corridor) to mark-to-market, which recognizes gains and losses in the current period, their timing appears unfortunate.

Although firms may not begin to recognize the financial markets impact on funding until their fourth quarter, analysts should begin to make these important adjustments to cash flows and financial structure immediately.


Kenneth S. Hackel, CFA


A Financial Metric That Has Never Been Wrong

September 2nd, 2011

Analysts track every conceivable metric, all trying to predict the next big move.  There is one metric, however, that deserves some very special attention in that it has never given off a wrong signal.

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