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• Decapitalization Impairs Prospective Growth
• Is IBM Vulnerable?

(full tables and charts available to CT Capital clients only)

Let me begin by clearing up a common misperception perpetuated by CFO’s during company conference calls:  share buybacks do not reward shareholders, only higher valuations and dividends do that. And because they do zilch to improve ROIC, they routinely force multiple contraction despite improved GAAP metrics, such as return on equity and per share metrics, including earnings and book value.

The logic is irrefutable: long-term shareholder value takes place through increases in free cash flows, with risk remaining at appropriate levels. This occurs via proper investments in assets, projects, and research, the polar opposite of what many firms are doing today in an appeasement to institutional shareholders.

Share repurchases are often construed as acquisitions identical to the assets of the firm.  This line of thought is incorrect for several reasons, not the least of which is the negative repercussion to cost of capital.

It can be easily proven that if an entity was able to purchase another firm having identical free cash flows, cost of capital, and normalized safe positive spread among the two, presuming its post-acquisition cost of capital remains unchanged, it should purchase the outside asset rather than its own stock, for by expanding its capital base, its prospective free cash flows, return on invested capital and economic profit would also grow, thus enhancing shareholder wealth. Likewise, if the free cash flows were used to reduce cost of capital, fair value would be enhanced. This is true almost regardless of the free cash flow yield of the acquired entity.

Berkshire Hathaway, during the period it was disengaged from share repurchases as it was expanding its capital base, saw its shares widely outperform the general equity markets, while, after announcing it was prepared to inwardly direct its free cash flows, has seen its stock underperform.

If a material[1] level of resources results in value-adding activities, shareholder value is enhanced. If invested capital or other opportunities were limited due to de-capitalization measures, investors will ultimately pay the price, as free cash flow growth is unstable and unpredictable for many periods along the business cycle; firms which engage in share buybacks with cash on hand also find their cost of capital ( and share price volatility) rise for the same reason.

If leverage is required to aid share buybacks, cost of capital rises and financial flexibility declines even more so. This may occur for reasons other than the attrition of the cash cushion, including workforce reductions, credit rating downgrade, incapacity to hold onto market share, instability of financial metrics and reduction in interest charge cover.

In furtherance of my argument, for firms like Apple, which have high (free cash flow) in relation to its capital base, share repurchases mean little in terms of enhancing shareholder value, even though the return on a large cash hoard is close to zero. In Apple’s case, economic profit is driving results, which, aside from product acceptance, is exceptionally high due to a very effective supply chain, including parts, technology services and assembly.

A leading indicator of management and Board effectiveness is the direction of the firm’s capital. Entities that have opportunities to deploy capital at rates consistently and safely above their cost have the opportunity to enhance shareholder value.  Unfortunately, most firms, as shown in the text box, rely on a surrogate cost of capital (stock beta) instead of metrics reflecting all known and possible risks to prospective free cash flows. For more information on this, see Security Valuation and Risk Analysis.

In acquisition analysis, the reliance on beta to depict cost of capital, managers and investors may be using inappropriate hurdle rates, thus unknowingly engaging in value destroying acquisitions.

Then there is the gray area, where, in fact most acquisitions fall. Such purchases may in fact be properly evaluated on the ROIC side but may raise cost of capital due to equity depletion, such that the firm is now constrained from engaging in prospective activities which may have added significant value relative to the recent material acquisition. This comment is of direct significance for entities engaging in excessive share buybacks, meaning the Board has approved the impairment to the financial structure.

It is to this latter point the balance of this article is directed, given my deep concern capital depletion will undoubtedly lead to subdued economic growth.  Believing the hype fed upon them by fear and greed, it is not uncommon to see firms commit a significant percentage of their free cash flows toward share buybacks, dividends and executive compensation (total direct compensation), instead of worthwhile projects and opportunities.

Firms such as Berkshire, Regal Beloit and P&G, have had long periods of successful acquisition programs due to their understanding of products, people, cash flows and risk, and by such virtue, have been rewarding shareholders. Former “high flyers’ often succumb to the falling stock price syndrome in the form of massive buybacks.

In this regard, technology firms could learn a lot from the manufacturing sector, which is not to say manufacturers have not made grievous errors, including the likes of GM, Exxon, and GE.

The Impact on Shareholders’ Equity

As a consequence of share buybacks, shareholders’ equity has, for many firms, including Sears, The Gap, and Wendy’s, fallen quite considerably from peak levels, despite strong cash flows and GAAP based earnings.  For firms in general, shareholders’ equity has risen just 17% for the S&P Industrials (see chart) from the March 2009 bottom.

For some well-known firms, the decline in shareholders’ equity has been dramatic, even  excluding material off-balance sheet liabilities such as pension plans and other benefits, operating leases and market value adjustments.

IBM-A Case in Point

IBM saw its shareholders’ equity peak in its September 2006 quarter at $34.3 billion.  Due to share repurchases it has been on a continual decline, currently standing (FYE 2011) at $20.2 billion, or 41% lower. IBM has placed the majority of its free cash flows into repurchases, boosting its GAAP metrics while its free cash flow growth since 2008 has been sub-par. If IBM’s economic return were to slow from its current level, its share price would fall greater than currently perceived due to the removal of its safety cushion. Would not IBM’s shareholders have benefitted more greatly if the company had not, over the past three years, spent two and a half times the value of acquisitions on share buybacks?  Sooner or later, IBM management must also come to grips with the underfunding of its foreign pension plans. Balance sheet pension (which is understated by at least 20%) liabilities grew by 11% during its past year and now accounts for over 90% the amount of shareholders equity. Investors have yet to focus on the liability for which, I am sure, IBM’s CEO is thankful. Although the company spent $33.4 billion on stock repurchases over the past three years, shares outstanding declined just 12% through September (2012 10-K not yet filed).

Invested Capital Steady Despite Fall in Equity

If IBM achieved 9% cash based ROIC return on the cash used for share buybacks, even allowing for the increase in shares resulting from issuance, its share price fair valuation would have increased by 23%, and, when the next downfall comes, its shares will have declined less.  Even if IBM had taken half the buyback to cut its pension liability, cost of capital would have declined by half a percent, adding about 12% to its shares fair value.

This point is illustrated as while IBM’s shareholders’ equity fell almost 13% from its year end 2010, its invested capital fell slightly for the year, $44.98 billion versus $ 45.45 billion. While IBM’s invested capital dropped from the 2006 level of $54.45 billion, such was due to the company’s shrewd exit from the PC business, and into software and consulting services. Over the past 5 years, IBM has altered its financial structure, now needing less of a financial cushion from the new business mix and other efficiencies. I believe, however, IBM, in its attempt to reach $20 per share in GAAP earnings, as it promised security analysts, it is taking on excessive risk while compromising worthwhile prospects, as is seen by its limited acquisition program. Meanwhile, its R&D budget has been flat for 5 years.

While supply chain and other streamlining aid cash flows, playing with equity as a means to reward shareholders is illogical. Shrinking equity will harm corporations as a whole, and, as such should be a concern to investors, analysts, creditors and lawmakers who may be considering following the IBM model. Recall only a few years ago to the worldwide financial crisis how important equity was to many institutions.

Perhaps Boeing shareholders would not have seen its stock price fall to below $30 in 2009 had the company not repurchased almost $3 billion of its shares during 2008, destroying equity. Boeing, which also has large liabilities not reflected in its financial statements, has yet to see its old highs. Its shares started recovering as its share repurchase program was halted and equity was rebuilt. Cyclical firms should almost always avoid share repurchases except for normalized free cash flow producers with low cost of capital wishing to offset share based compensation. Analysts must deduct those tax based effects listed under financing activities in the statement of cash flows in their cash flow models, such that the real impact of stock-based compensation is reflected, including tax affects.

I look forward to the day I hear investors grill companies on their misuse of capital. Today, revenue growth is the most desired metric.  Although product acceptance is of utmost concern, one must recognize it takes assets and capital to have that come about, something that is destroyed through capital depletion.

Kenneth S. Hackel, CFA

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I just heard an analyst from a leading firm state one of his primary metrics is return on equity.

Return on equity is important is important only as it provides a reflection of the firm’s return on capital.

For an obvious case, look at Apple, whose ROE pales compared to its ROIC as the firm is extremely adept at deploying cash as well as using other firms assets. In fact its equity is mostly cash.

If two firms have similar ROE, yet one has a higher ROIC, almost always go for the firm with the higher ROIC, as deploying cash into productive assets will yield higher free cash flows.  Its cost of capital is also important, especially as it reflects its financial structure.

In today’s investment marketplace, where many firms are overflowing with cash, the ability to redeploy cash having a low after-tax tax yield into projects and assets having a high return on capital will, in most cases be value-adding opportunities. If the firm is unaware of, shy regarding acquisitions, has a high cost of capital, or whose opportunities are currently producing low ROIC,  deploying cash into new projects may be questionable. Mere accounting manipulation-such as an asset write-down-will improve ROE, as will a share buyback, yet both activities will not improve  ROIC.

It is for this reason why investors and analysts should measure and prefer the cash on cash return in their acquisition analysis, to which ROE has a back seat. Income from cash is not included in the return on invested capital (ROIC) metric.

Example UPS

To calculate UPS’s return on invested capital, I employ the definition espoused in Chapter 5  of my book Security Valuation and Risk Analysis, and the information contained in is 10K.

ROIC =Free cash flow – Net Interest Income/Invested Capital (Equity +Total Interest Bearing Debt +PV of Operating Leases-Cash +Marketable Securities).

UPS had produced normalized $2.9 billion in free cash flow from which we

exclude its $100MM in net interest income as we are seeking its return on capital

employed.

=2.9 -0.1/6.78+ 9.87 +1.1-1.05

=2.8/16.7

=16.8% excluding loss in comprehensive income

=12.5% including loss on comprehensive income

Incorporating operating leases into the denominator lowers UPS’s ROIC by about

6 percent. If the loss on comprehensive income (or part of it) were added back to

shareholders’ equity, the difference would have been meaningful. The

company’s ROIC is sufficiently above their weighted-average cost of capital

(8.35 percent) to state that UPS most likely has many value-adding investments

it could make.

This would not be as apparent by merely looking at its ROE.

Kenneth Hackel, CFA

CT Capital LLC

www.ctcapllc.com

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November Summary

While the past week’s rally was certainly gratifying, recent large price swings represent investors’ admission they are uncomfortable in their ability to assess the current level of credit risk.  Access to capital at a reasonable price is vital to our economic well-being and weighted accordingly in our valuation models. Even for firms having strong credits, their suppliers or customers may be at the mercy of lending institutions.

I remain slightly concerned the coming bank stress testing, in spite of today’s actions by the Fed, ECB and other central banks, could further constrain the supply of capital, placing the industrialized economies in greater jeopardy than need be. We are already seeing banks restructure balance sheets to provide regulatory Tier 1 capital, and in the process, limiting lending to mid-scale businesses.  If these concerns are not realized, fully expect to see equity markets undergo valuation multiple expansion as the cost of capital should fall from its current 9.1% down to the 8.6% range. This alone could fuel a 25% rally in valuations.

While raising permanent equity is appreciated by creditors, greatest efficiency occurs when capital is at an optimal point—excessive capital is not always the solution and can harm valuation multiples while increasing cost of equity as it lowers prospective return metrics.

Credit concerns began in August, almost coincident with the fall in stocks. In the chart appearing below, measured is the interest rate being charged by London banks, in US dollars, for loans to other banks having a 3 month maturity. While this and other real-time metrics, including credit default swaps, have become an important component in the setting of cost of capital, they do not rule the roost—longer-term free cash flow, return on capital, cost of capital and valuation do.

The balance of the report is available for clients of CT Capital LLC

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Portfolio Review- October 31, 2011

Summary

Despite a sour windup to the month, free cash flow multiples expanded from the cruel levels in September. The portfolio is showing out-performance against both the Russell 1000 value and Russell Midcap since inception of the account this year.  That said, investors would be prudent to expect a prolonged period of slow worldwide growth, the kind of environment which is beneficial to our invested firms-those with sound financial structure and ability to earn superior returns on capital.

Devoting lots of time reviewing our firms almost weekly acquisitions, it was nice to have it go the other way with Healthspring receiving an offer close to fair value, and as a result the position was sold. Other portfolio firms have, by and large, reported free cash flows and either return on capital or economic profit, and financial structures, in line with model requirements.

I am devoting this month’s letter to one position (Regal-Beloit-RBC) which in many ways, epitomizes the portfolio—an industrial manufacturer which has seen its stock decline resulting from the current and likely to continue,  economic malaise, typical following deep credit crisis.

In the following example, our models, which include the alteration to RBC’s financial structure as a result of its most recent, and large acquisition[1], indicate an undervalued cash flow stream available to the equity holders. This is also evident on a historical basis by the chart at the end of the report, showing RBC’s historical three-year average free cash flows and market values. The chart shows investors have always responded favorably, although it often took an ensuing economic expansion, to respond to the firm’s improvement in operations resulting from its operating and financial decision-making.

Regal-Beloit Corporation (RBC, market capitalization $1.7 billion)

A firm with a normalized consistency of metrics for a cyclical business, a history of value-adding acquisitions, and a free cash flow yield which over the cycle is safely above its cost of capital, Regal Beloit shares, despite above-market volatility, should continue to provide above normal return to shareholders.  The firm’s shares, since inception of the account, have been underperforming the benchmark. Over the long-term, its superior metrics have resulted in outperformance, and in fact, was a position I owned for clients over 20 years ago. Management has continued to employ and promote executives who believe in the time-tested and economically proven philosophy of acquiring firms which exceed its cost of capital within one year. Smaller acquisitions, it appears, have taken longer to become value-adding, although financial details are sketchy at best with such deals.

As organizations strive to improve energy efficiency, and with RBC enjoying a pre-eminent position in motors, generators, and electrical manufacturing, benefits should accrue continue to both equity and credit holders.  Prospective results should also be bolstered by the recent AO Smith electrical products division acquisition, which has a stronger presence in faster growing markets.  RBC has leading positions in Asia and North America and is attempting to be 50% non-US in total sales.

Management has kept to its knitting in their “bolt-on” acquisitions (14 in the past 36 months) in which the firm has a knowledge base whereby it can be a better owner than the seller, meaning, it can improve upon the financial metrics at the time of acquisition. It also has a history of making good fits, culture wise, always and an important yet somehow underappreciated consideration in merger analysis. Their larger acquisitions tend to be those which RBC has a long history of competing and has deep familiarity in both product and people.

RBC funded the AO Smith purchase with cash, equity, borrowings under their credit facility and additional debt. The size of the acquisition (41% of its market value, amounting to $700MM in cash and 2.8MM shares of stock) and the impact to the financial structure caused us to raise cost of equity by half a percentage point. Of the $700MM, $500MM of long-term debt is at 4.74% with a $100MM revolver at 2%. RBC expects large cross selling opportunities, which is often overlooked in these type of mergers, as analysts prefer to concentrate on cost synergies, which RBC estimates at over $35MM over 4 years.  I believe RBC will be able to pay down the added leverage rather quickly given data from the seller’s 10-K’s and RBC’s ability to improve upon existing, as well as internal, cash flows.

Total debt as a percentage of total capital, due to the acquisition, is at the company’s historic high range, even when bringing the debt to present value.

RBC claims they will, despite the current economic climate, continue to be active acquirers; I view this as a positive as most well financed companies shy away from acquisitions during slowdowns. If however, any upcoming deal is not immediately value-adding or brings the financial structure out of line with normalized free cash flows, or brings its cost of capital above acceptable levels, our positive position will be re-accessed.

RBC is comfortably within all loan covenants. Capital spending, despite its acquisitions, is higher than normalized, in part due to the requirement of the Chinese Government to relocate 2 of its plants while funding a manufacturing facility that was previously leased. Our worksheets (see table-excess capital spending) reflect these expenditures. Litigation is normal and derivatives within fair hedges. Pension liability adds 16% to total debt, and operating leases about 8%. Purchase and other commitments, including outstanding letters of credit are normal. Although the tax effective rate has remained in a 30%-35% band the past 7 years, its cash rate has been more erratic, owing to credits and other normal factors. NOL benefits are minimal. Unremitted US earnings are $131 MM.

The free cash flow worksheet shown below (and attached for larger print reading) is for the six months ended June, as the current quarter results are not to be released until November 2. One would expect a below average performance given the macroeconomic factors, results from other cyclical firms, and acquisition related expenses. As you have seen, yearly worksheets are more detailed and reliable, given firms’ estimation procedures and the incorporation of additional data.

As the half year worksheet illustrates, RBC has been able to continue to show the ability to produce superior free cash flows, resulting in a cash yield above that for the median S&P industrial entity, a fact being currently overlooked by investors focusing on the general economic slowdown and the European debt crisis, rather than the gathering of the firm’s operating leverage, which I believe will become quite evident as those problems unwind. RBC, as with other firms doing business in Asia, is seeing a noticeable slowdown in China; they are not overly exposed in Europe.

Included in free cash flows is part of last quarter’s $28MM charge from the addition to their warranty cost provision due to a defect, shown in cost of goods sold, and with the total charge to be paid over upcoming current quarters.

The models also added minor free cash flows due to higher than normalized input costs reflected in COGS, which grew to 77.8%, due to higher commodity and other expense. The models added other free cash flows to operating expenses (SG&A) which were high relative to historic levels. As sales grow, new acquisitions absorbed, the supply chain continuing to be squeezed, and acquisition related improvements placed, I expect these expenses to normalize. Given general economic weakness, however,   it might take a while longer than management currently believes. Regardless, employment cuts should be expected which could free up cash not fully reflected in our models which partially pick up a percentage (between 15%-20%) of the excess expenditures. Other discretionary expenses are within normal limits.

Half of RBC’s employees are covered by defined benefits plans which were frozen in 2009; foreign employees are covered by government sponsored plans.  As stated, we added 16% to total debt to account for current market rates based on RBC’s somewhat high 8.25% investment assumption (72% in equities) and 6% discount rate assumption. We have also penalized cash flow from operations based on the announced $2.2MM contribution this fiscal year and cash payments running slightly under $5MM. Most US employees participate in their savings plan.

The following chart shows the relationship between Regal Beloit’s three year average free cash flows, as defined, and its corresponding market values. We also show trend lines for each series. As is not unexpected for cyclical manufacturers, the lines are somewhat jagged; the trends however are unmistakably close and positive, which has resulted in strong performance for the patient investor.

The free cash flow worksheet shows higher free cash flows than the company has, in its presentation slides, been reporting to shareholders.  The reasons are twofold. First, we adjust for normalized expenditures, including commodity costs, which have impaired the results of RBC. The model also picks up and includes as overspending, excess expenditures, and since RBC has been an active acquirer, the model accounts for some reductions in labor and other cost redundancies. In fact, during its most recent conference calls the company admitted it is diligently working to reduce expenses from acquisitions.

We recognize firms like RBC will always be impacted by economic forces, as will be seen again this coming week. However, once an expansion takes hold, however slight, and as energy becomes costlier, and the benefits of its most recent acquisitions return cash to reduce leverage (and cost of capital), investors will begin to appreciate the superior normalized yield.

Please call me with your investment questions.

Ken

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Learn the techniques of cash flow and cost of capital. If you are not making serious adjustments to published financial statements, you really need the book to your right.

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The following is a distilled version of that sent to clients.)

Quarterly Review- September 30, 2011

A Disappointing Quarter

When the financial markets have difficulty quantifying risk, volatility is the conventional result.

The inability of investors to find comfort with their projected return on investment has undoubtedly forced the cost of equity capital considerably higher than should have otherwise been the case, even given current circumstances. Whereas, I have constructed models specifically for this purpose— risk analysis—which normalizes historical and current metrics, and as importantly, carefully evaluates those metrics which could cause prospective cash flows and financial structure to deviate, even wildly given historic volatility, the financial marketplace has, our work shows, overcompensated for such risk. When investors ratchet down their queasiness levels, even given below-normalized cash flow estimates, we should begin to see equity markets improve rather quickly. In fact, I surmise earnings and cash flow estimates have not changed with the drama one would have expected given the quarter’s decline in share prices-rather it was the discount rate applied to those metrics.

History has indeed shown firms always snap to new highs from disheartening and ungraspable valuations.  Over the past three months, leading quality energy shares were down 21%, materials 25%, copper shares 41%, and insurance 22%.

Good news from quite a few firms in other sectors has fallen on deaf ears.

Investors in the midst of bear markets tend to believe that “this time is different.”  And, while each recession and bear market leaves its own imprint, with each depth of varying proportion dependent on the cause, strong fiscal and monetary inducements eventually come riding to the rescue. This is followed by a renewed sense of confidence, or at least an uplifting of “worse case scenarios.”  Thankfully, there has never been a recession, bear market, or depression, which did not eventually end, although given the severity of the 2007-2009 credit crisis, investors should have expected a long recovery period.

Despite what I might have believed at a younger time, I have come to learn everything ends and nothing stays, which at least economically speaking, we should accept as more than a snippet of optimism, even factoring news the Chinese economy is not immune to the rest of the world.

The industrialized world’s economic malaise had its seeds rooted in the 2008-2009 financial, credit, and sovereign crises, from which the weak credits never fully emerged. No permanent solution was offered and none accepted.  The blood transfusions and loose bandage held for a short time as investors prayed the wounded would somehow self-heal.

The crisis will end, but not before stronger, permanent solutions are put in place. This, of course, applies to our own sovereign struggle, which must include altering entitlement programs and means testing, as well as changes to the tax code.

In the corporate world, left standing stronger will always be enterprises which share the characteristics we hold in highest esteem- the rich and thrifty.  I have never owned for clients a firm which went on to fail, even years after we sold.  The CEO’s and Boards of our investments have, for the most part, been deploying resources having an expected safe and consistent return in excess of their cost

Despite a supply/demand equation balanced on a needlepoint, copper and energy shares fell sharply during the month with an extreme swing in copper pricing. Since reporting, commodity prices for these resources have cracked and with it their shares, yet several well-placed analysts predict a shortage for next year^[1]. As the pendulum swings back toward equilibrium, share prices will propel as quickly upward as they have downward. The price of copper, even at its current $3.15/lb, a 14 month low, is above Freeport-McMoRan’s $2.50 marginal cost of production.

Novo Nordisk, one of the world’s truly great companies, saw its stock fall 9% during the month, which I can only tie to exchange rate differentials—the company, as of its last reporting period, is performing in line with expectations, and raised guidance concurrent with its last release.  All metrics from sales to free cash flow, margins, and return on capital are far superior to the median firm in the S&P Industrials.

Novartis announced one of its drugs curbs breast cancer, with a Harvard Medical professor being quoted saying “This could be a game changer.”-Its stock, despite coming off a solid quarter, fared poorly for no apparent reason-and I don’t count swings in currency as a legitimate reason given firms like Novartis.

Odds and Ends

In the “ahead of the curve” front, a potential tax bomb awaits many firms when Congress forces the US tax system away from LIFO accounting. I believe this is a virtual certainty, given (1) the long-overdue shift to International Accounting Standards and (2) the large domestic deficit. The inevitable result will be reduced cash flows and valuations for the effected firms.

Kudos to the SEC for seeking additional disclosure on companies offshore cash. There is no such current rule, and therefore we estimate a tax on repatriation based on reporting segment data and an average cash tax rate, if not disclosed during conference calls or other public documents. Many companies hold essentially all their cash overseas, while a considerable number of large firms hold over 50% of their cash in non-US accounts. Firms that have substantial amounts of offshore cash can bid higher for non-US firms to earn the same, or higher, ROIC.

During the quarter, there was renewed focus on supply chain management. While this resulted in lower orders and revenues for many firms as the process works throughout the system, it will help eventually reduce the volatility of the current and future cycles. For those firms which can streamline costs, the savings will boost free cash flows.  Together with existing cost reduction programs, operating leverage during the next expansion should be more impressive than investors are currently recognizing.

Health care expense is rising at a greater rate than expected. For firms with inappropriate health care cost trend rates, we have adjusted the cash flows.

Kenneth S. Hackel, CFA

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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 30^th, 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.

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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

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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

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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.

The balance of the report is only available to paid subscribers.

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Report available to paid subscribers

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Starting September 1, we will be offering a higher level of service on a yearly payment basis. Clients of CT Capital LLC will be granted access.

Each week, we will be highlighting a company or companies presenting risks and reward, which the investing public, and even perhaps these firms own Board of Directors, may not be aware or are underestimating. Everything from financial engineering to taxes. Any risk which could potentially impact a firm’s cost of capital, which we define as risk to prospective free cash flows, is considered.

Special reports will be written as well, covering both broad areas of the equity market as well as recent news items.

For subscribers prior to September 1, the cost is $ 2,500 per year. After September 1, the cost will rise to $ 5,000 per calendar year.

The reports, covering both cash flows and credit, and will be based on the principles outlined in “Security Valuation and Risk Analysis.”

To subscribe, email us.

Kenneth S. Hackel, CFA

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You’d be foolish to rely on others when you can do a much better, detailed job yourself.

With the book to your right, you’ll be able to uncover risks your brokerage firm or investment advisor is not aware of.

You’ll see why their analysis, in many cases, has been way off base. You will learn how to make the proper adjustments to the published financial statements and footnoted items, and other analysis your current adviser is not performing.

Relying on a firm’s financial statements presents risks. Companies can manipulate many activities and payments, to present themselves in a light which may not represent the true picture of cash flows and credit.

By following the methods outlined in the text you will be placed in a superior position-the result of my nearly four decades covering all phases of finance-from investment advisory, research director,  to fairness opinions. See how I took over the worst performing equity mutual fund for a year and made it the leading fund.

Wonder no more why a particular stock is falling without seeming reason, or which stocks present superior potential.

Buy “Security Valuation and Risk Analysis”.

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How to tell if the investment advisor or security analyst you speak to is “worth a hill of beans.”

Ask the following 3 questions:

1-Explain, in detail, once you’ve estimated the entity’s free cash flows, how you arrive at the discount rate?

HINT: It’s not what you learned in grad school or the CFA exam.

2-Explain, again in detail, all of the adjustments you make to the published financial statements, to arrive at an estimate of free cash flow?

HINT: Lots of adjustments are required.

3-How do you define return on invested capital?

HINT: We’re looking for cash on cash.

For the real answers, see “Security Valuation and Risk Analysis” or call CT Capital LLC

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You may have recently become aware of several new investment products based on portfolio stability factors. If you are interested in an equity portfolio composed of firms, which, by their nature, exhibit considerable financial stability, you should surely be attracted to CT Capital LLC. This is an area we have focused on for almost four decades.

Operating and financial stability have always been critical to risk analysis and investment performance, as well as how firms themselves should be managed, including capital deployment and financial structure.

Whereas the stability products that have been introduced by other firms are keyed off of quite basic metrics, the CT Capital LLC portfolio is based on a comprehensive array of detailed models that do not exist elsewhere. Our worksheets utilize both historical and real time data.

For example, a recently introduced product from a well-known firm uses balance sheet debt/equity as a stability measure whereas we include all forms of debt in our leverage ratios, including unhedged derivatives, unfunded pensions using real time assumptions, leases built in for growth (not the footnoted minimum amount), moral obligations, realism behind health care assumptions, workers compensation, purchase agreements, self-insurance, and so on. Other firms are using GAAP data; we use cash flow, and, where appropriate, normalized (smoothed) results. Our cash flow models adjust for firms which might have “managed” their assets to produce cash which, if not been managed, would have reported poor cash flows. This would include balance sheet and credit decisions geared to producing short-term cash when the financial structure is weakening as might be the risk of growth to prospective free cash flows.

We incorporate stability measures in everything we do, from sales and input costs to taxes (both effective and actual).

We evaluate and measure sovereign risk, insurance, litigation, patents, covenants, and any and all factors which might lead to a change in the firm’s stability. This, in fact, forms the basis of our cost of equity capital.

Half of our analysis is dedicated to cost of capital as it is the most important factor in risk analysis. Cost of capital and stability go hand and hand.

If you are an institutional investor, call us at CT Capital LLC and we will explain how a true stability led portfolio should be constructed.

Kenneth S. Hackel, CFA

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Arguing for a Active Investment Strategy
A recent study by Peter Mladina, Director of Research of Waterline Partners, which advocated the taxable investor own primary passively managed equities and other passive investments, is not without flaws.

The author concluded an active manager needed to show outperformance of 380 basis points (his “triple net” alpha) over a passive strategy to essentially break even in terms of similar after-tax return.

I have found most active strategies fail due to a misjudgment of risk (cost of equity capital) and incorrect definition of free cash flow. In this case a passive strategy is preferable. However, with more precise calculations of these variables sustained outperformance can be achieved.

I see little to nothing new in the paper’s general conclusions. A passive strategy, of course, works in general, as the universe cannot outperform itself when fees and other costs of an active strategy are deducted. There are other advantages of the passive strategy mentioned at the conclusion of this response. Of course, the paper is based on historical and normal results, which may be at odds with prospective happenings.

Major Reasons for Active Manager Underperformance
Security analysts, in general, do not understand-let alone quantify- the deep and often buried list of risks firms confront. A thorough insight into risk forms the basis of the discounting mechanism (cost of equity capital). A lack of awareness of these “hidden” risks (i.e. Moral obligations, derivatives, mergers or other business combinations, financial structure, pension and other benefits, taxes…) forces a valuation that is not consistent with, nor reflect the true valuation of the entity. My response here is not meant to be too great an advertisement for CT Capital but our detailed evaluation of risk as a key factor in what I believe will lead to outperformance vs. benchmarks and other active managers. I would encourage you to ask security analysts, equity managers and other investors and consultants how they arrive at the discount rate, and what they believe it is meant to capture (correct answer: risk to prospective free cash flows).

Most security analysts, investors, corporate finance analysts, and investment bankers do not understand how to measure free cash flow. I have worked all sides of corporate finance and investment advisory, and by failing to account for, including proper (re)classification and adjustment of items in the statement of cash flows, income statement, and footnotes, outperformance can only take place through luck, and I do not believe in luck as a fitting methodology outside the casino. The free cash flows are the income to the investor and its yield forms the basis of metrics used in capital decisions, including the margin of safety between the cost of capital.

So, if risk and free cash flows are not properly measured, a passive strategy makes sense. Ask yourself, what makes Warren Buffet so smart? The answer is simple: he buys assets that meet the above criteria, even though even he sometimes gets off the beaten track with regard to risk.

Back to the Paper…
I find fault with several of the assumptions in the paper. For example, the author’s “required triple net-alpha,” is derived thru a backed-into calculation after other variables are known. Unfortunately, those variables are at odds with the costs and expenses available to most large investors. Building upon the 7.77%, (which he uses as the average historical return) across the board does not recognize these more realistic assumptions and thus throws off the remaining calculations that differ with the passive strategy returns.
Let me also point out even an active strategy of a diversified portfolio based on ETF’s finds expenses much closer to the passive strategy expense other ratios’.

In some ways the author’s entire argument is circular as it assumed a manager would need to outperform by 380 basis points in order to make up for active management costs. However, those higher costs are a result of taking advantage of opportunities that a passive fund cannot (e.g. managers do not trade more for the sake of racking up higher commissions but because they believe they have superior information).

The 1.35% expense ratio, 0.89% in transaction costs, and 94% turnover, are over three times that at CT Capital LLC, as we trade at 1 cent per share with moderate turnover. I believe all three estimates are considerably higher than necessary to achieve outperformance. Mutual funds that incur research costs via commissions often do pay the higher fees quoted by the author, however this is an unnecessary expense avoided by investment advisors who use their own research teams and models. The author also quoted studies that were themselves faulty.

Regarding the tax assumption, as investment advisors tend to hold their unrealized gains over longer holding periods than realized losses, this assumption is also exaggerated.
Also, the 7.77% result used as the basis, is the return before transaction costs. I have not seen advisors report this way, although I understand what the author is trying to get at-the added return over passive- in actuality, it is unrealistic.

When adopting more practical expense, transaction costs, and tax assumptions, for a moderately trading investment manager, the triple net alpha is cut to about 73% less than the author’s ’ 380 basis point triple net alpha, or 1.03%. An investment manager in equities that can consistently outperform by this magnitude would be roughly equivalent to the author’s passive results. To believe a gross annual 380 basis point return is required over a passive strategy is unrealistic and not supported by fact and reality existing in the marketplace. I have recently seen active managers charge very low fees, not to distant from passive fees, for ultra large accounts. With worldwide economic growth slow, it is in this direction fees and expenses are headed. Actuarial assumptions have rarely been met over the past decade, and cost reduction is the preferred solution.

Conclusion
The passive strategy will make sense for a long time to come, although the quoted required gap (triple net) is exaggerated. Faulty security analysts, the large benchmark indexes being of considerably higher quality than the equity market as a whole, the taking of undue risks by the investment manager universe, and the identity of the whole not being greater than itself, are the reasons. On the other hand, active fees and expenses are incontrovertibly headed down and will soon provide stronger competition with passive products, including ETFs and indexing.

Unquestionably, a clandestine reason for the growth of indexed products has been the guidance and education of security analysts. Historically, except for perhaps the CFA program, which even itself is lacking, analyst training is constituted more of on-the job instruction than what is really needed, but admittedly impossible to pull off-that of on the job training at various firms in the industries covered by said analysts.

However, if investment consultants, pension sponsors, financial journalists and other advisory firms find the superior analyst and process, extreme value will be provided over the passive strategy. I have seen firsthand, over four decades, how an active strategy can earn returns many times that of a passive strategy, taking into account the greater fee and tax effects.

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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

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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.”

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