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.
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
