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Review- March 31, 2012

April 3rd, 2012
Portfolio Review and Comment – March 31, 2012
The accounts had a good quarter—outperforming all benchmarks by a wide margin the first two and a half months, only to then abruptly retreat, precipitated by the steady drip of disconcerting economic news in China, a major engine of the world economy and sparkplug for the more cyclically inclined businesses. Although we have been warning of such weakness for some time (see first comment under “Review” section), the sell-off is almost certainly unwarranted.
Apple’s exclusion also negatively impacted relative performance, as it was responsible for about 13% of the first quarter’s advance in the S&P 500, a greater percentage since inception. Our models are indicating that Apple, despite being the world’s largest public company, strongest credit, and having a striking short-term outlook, also now carries risk to its valuation, which should become apparent over the coming year. This includes size, sector, stability metrics, reliance on China, as well as political and consumer pressures related to its success.
The accounts are nonetheless outperforming all the Russell benchmarks for the quarter and since inception.
A recent purchase, Quest Software, which I had intended to detail in this space on valuation and consistency, received a takeover bid in a financial led-deal, and was sold. I will highlight another holding next month hoping it meets with the same fate. While the Quest deal could not overcome the valuation contraction in our economically sensitive, ultra-high quality portfolio, I look forward to the stabilization of the world economies, which, as it takes hold, will truly accentuate our firms against the benchmark indexes.
Our models are particularly sensitive to mispricing of normalized free cash flows, return on capital and cost of capital, the latter a strong function of financial structure as well as any potential risk to prospective free cash flows. And at present, it is in these underperforming sectors where the greatest opportunities for superior returns exist, hence the current weighting. I (and you) should expect the mispricing will be corrected rather quickly when normality is restored. Superior returns are rarely seen for those who prefer to “wait and see.”
Last month I wrote “the more economically sensitive groups will see steady metrics in the normalized range for the coming six months- as opposed to growth. This could conceivably lead to some multiple contraction for the affected shares…” This has taken place as business in China has indeed continued to abate, and for some firms, contract, over the prior year’s results. I expect these stock underachievers in our portfolio to see improved valuations in the second half of the year given the sustained reduction in customer supply chain inventories with commensurate loosening of credit by the Chinese authorities in an attempt to combat a further decline in real estate values.
While the preponderance of firms selected by our models, including subsequent qualitative evaluation, are sensitive to economic and unique market niches, such as Ancestry.com, so too are their valuations. So, while US stocks have seen multiple expansion, many internationally exposed firms have not seen the improvement to return and cost of capital in the U.S. I therefore believe the investment performance of the non-cyclical portion of the portfolio also has quite a bit of run in it.
 Despite the rise in U.S. interest rates during the quarter, with 10 year treasuries closing to yield 2.2%, long-term debt money remains cheap and especially so for normal consistent taxpayers. They thus represent a minor hurdle when comparing equity valuations to the treasury yield and for potential margin of safety for firm financing of capital projects. Yield spreads, an important metric in our models, narrowed, helping motivate the expansion in most sectors valuation multiples during the quarter.
 The chart below shows the 2 year swap, with data from Bloomberg ( CHART NOT SHOWN).
This year, average spreads on investment-grade bonds have narrowed to 184 basis points from 234bp at the end of 2011, according to a Barclay’s index. Average yields this month fell to 3.27 per cent, the lowest level since the index began in 1973. Our models use this index for firms which have no fixed income instruments (American Eagle, Garmin, Nice Systems, and True Religion) when evaluating cost of capital, for such firms are still impacted by credit spreads, as we saw during the credit crisis. .
Most companies do not see a significant upward turn in Europe this year, leaving cost savings as the prime motivating factor influencing free cash flows and return on capital. An entity’s ability to improve its return on capital is now an especially important metric, as opposed to periods when top line growth in anticipation of a higher ROIC down the road bids up share prices. Fuel prices are now beginning to provide headwinds to some of the recent cost improvements for business. Our model considers energy prices a separate component to cost of capital, hence valuation multiples.
Coming Capital Shortage? 
It is conceivable a capital shortage is on the way, and so we are gratified by our models ability to monitor and probe for changes in financial structure and access to capital, whether through low cost commercial paper or facilities with strong lenders. Being barely removed from the worldwide credit crisis, I am seeing large capital deployment for many firms where improvements to improving return on existing capital should be taking place; for much of the world, the deleveraging process has years to run.
I fear a restrictive credit scenario for its effect on cost of capital and fund raising—both debt and equity. One can certainly recant the many firms— including WorldCom, Calpine and MTG, which went from investment grade to junk in a matter of months. And yet, in these and other case histories, corporate boards had the power to limit the “worst-case scenario” through the prudent allocation of capital.
A capital scarcity could occur due to bank lending capital restrictions, zealous monitoring by regulatory agencies and congressional oversight committees, as well as the close out of pension funds defined benefit plans, once a source of massive flows of capital.
Of course, share buybacks remain the principal culprit. The S&P 500 group, over the past four quarters, repurchased around $434billion in their stock while paying $221 billion in dividends. Too many firms pay out over 70% of their cash flow from operating activities for a combination of dividends and buybacks.
Security analysts must pay strict attention to, and the impact resulting from, firms’ cash being deployed on poorly thought out acquisitions, including purchases having uncertain payback periods and large deviation of the yearly free cash flows relative to the cost of capital. This is typical of slow growth periods where managements try to buy revenues and market shares and why our stability metrics cause a high build into cost of capital into certain sectors, such as oil refiners.
This same logic applies to our penalty to cost of capital for large capital spending programs.
Alternatively, firms that build cash reserves could very well find their competitive advantage widening over firms with shrinking equity. While investors enjoy getting dividend checks, banking system and sovereign risk issues are too far from resolved not to prudently identify projects that could better maximize shareholder value.
There will, as always, be many value-enhancing opportunities for firms with strong financial structure to gain access to assets which produce high returns on capital. I believe our firms will be among such opportunistic buyers if they “play their cards right.” This capital shortage I fear will be exacerbated by excessive trading desks that are responsible for an overwhelming percentage of stock exchange volume—but harm the system by raising cost of capital.
For instance, this past month, shares of Sauer-Danfoss (SHS), the global manufacturer of hydraulic equipment declined 19% one morning on very heavy volume as the company reported some weakness in their business in China. My issue is that with 48MM shares outstanding in SHS, of which 36MM is owned by its parent, short sellers are taking advantage of both unsophisticated and even professional investment advisors who believe share prices represent “the truth and nothing but the truth.” Suppliers, who can be unknowing as well, might suppose a company is experiencing problems and contain credit, while workers, by virtue of the decline in their “paper” net worth,’ evoke a decline in productivity. In the case of SHS, a 5% reduction in their coming year’s free cash flow should not have forced more than a 5% fall in the value of their shares. SHS generates normalized $220MM in adjusted free cash, including payments to its majority owner, realistic cash pension payments, recapture of overspending on R&D and SG&A, against a $2.3 billion market value.
The growth of super fast trading firms has done nothing to build confidence, does not provide important liquidity, and raises cost of debt and equity capital.
I am pleased to report that Regal-Beloit (RBC), whose valuation multiple was hammered in 2011, yet which I have been reporting in this space as engaging in one value-adding acquisition after another, reported a quarter that positively surprised many investors, sending its shares higher. I believe RBC remains quite undervalued despite the economic slowdown.
My analyses over the years have consistently shown investors ignore the smaller, yet over time, significant value additions that RBC engages in. While any particular acquisition, especially of a privately held-concern, almost always goes unnoticed, the conversion to public company valuation of many such deals can create surprising additional value.
Other Holdings By far, most portfolio holdings reported above average normalized free cash flow and return on capital metrics, yet, despite that, their shares did not react accordingly. I have been through irrational behavior too many times to recant. Wall Street analysts fall over themselves looking for negatives having little or loose bearing to investment reality— such as Nike and Accenture which, during the quarter made the prudent decision to price competitively.
This month the Federal Reserve reported MetLife had failed its stress test whereby examiners tested its equity given a 13% unemployment rate and a 50% decline in stocks prices, hardly a plausible scenario. Yet, it was not MetLife, the company which failed, but MetLife’s management, whom, after the Fed refused approval of a share repurchase six months earlier, was now asking the agency to support $2 billion in shares repurchases and a 48% dividend hike. Had management been prudent in their request, and had Fed examiners really understood the securities and associated risks with each of the company’s asset tiers, MetLife would have easily passed the test, even though the company claims—and rightly so in my estimation—the Fed’s analysis was faulty. In Europe, where Solvency II comes into force January 2014, setting out stronger EU-wide requirements on capital adequacy and risk management for insurers, MetLife will easily exceed requirements, according to my analysis. Hence, we agree with MetLife’s response to the Fed, that they “don’t understand their math”.
Personally, I am gratified MET will not—for the moment at least— waste cash on a $2 billion repurchase program, inasmuch as the firm’s recent ALICO acquisition has proved to be value-adding. In addition, the stronger financial structure will lower weighted average cost of capital. The cash which it had requested to be distributed out of the company will rest comfortably on its balance sheet awaiting a useful purpose, or until MET sells its bank, at which time the buyback issue will almost unfortunately but assuredly be revisited.
Covidien, the medical equipment and pharmaceutical manufacturer announced it was spinning off its drug business. We are planning to sell the medical equipment component, deploying the cash proceeds in exchange for the drug component, given the expected valuation. This segment offers very steady returns on capital and consistency of free cash flow growth, in excess of benchmarks.
Express Scripts (ESRX), an impressive generator of free cash flow accentuated thru large-scale acquisitions is awaiting FTC approval for the purchase of former CT Capital holding Medco Health Solutions (MHS). Should the deal go through, as expected, ESRX shares should benefit by investor discounting of additional growth in free cash flows and return on capital. ESRX would own 59% of the combined entity. Management of ESRX is extremely aggressive, both in acquisitions and buybacks, and is a firm whose shares are particularly inexpensive, despite the share repurchases. Buybacks should moderate due to the large liability (additional $8.4 billion+) incurred to help pay for the deal. The free cash flows of MHS are sufficient to service the debt and should enhance shareholders equity and its stock price. If buybacks do continue at its recent pace, the position could be let go, as risk to financial structure might be tilted.
I would have thought Google would have seen greater multiple expansion given estimates of a market value for Facebook of upwards of $75 billion+, or a free cash flow yield of a fraction of Google. Although Facebook shares would be undervalued if it were to grow its free cash flows 50% per year over the coming 4 years, at this juncture our models prefer Google, especially with Facebook’s limited operating history.
My studies have long shown, that even for ultra-consistent free cash flow producers, when undergoing large (accentuated by net borrowing greater than 20% of equity) capital spending programs, their stocks tend to underperform. Corning will complete such a program this year, and as such, I expect its multiple valuation multiple to rise upon completion.
Sovereign Risk
The factors we look at in examining sovereign risk improved this past quarter, reducing cost of capital and reducing the discount rate used in equity valuation. The one exception was Argentina. Although we do not own shares domiciled there, last year we bought and sold YPF, its largest energy company. This past month, the Argentine government sent out invitations to reclaim oil areas owned by the company. I bring this up as another Argentine company made our quantitative screens this month, Pan American Silver (PAAS), and was summarily dismissed. This company goes through hoops when converting payments back to dollars and in forced buying requirements.
The slight rise in interest rates this quarter leads me to the following illustration (NOT SHOWN) , which shows the required normalized free cash flow yield demanded by our valuation model compared to the current 10 year Treasury note. As seen, lower interest rates command a higher percentage premium, while during periods of rising rates, the spread narrows. For example, at the current Treasury yield, we demand a minimum 3.35% free cash flow return while at 13%, a historically rare event, we demand a free cash flow yield similar to the 10 year instrument. At very high rates of inflation, valuation multiples are severely compressed, while, in practice, this has shown to be opportune times to invest as yields have subsequently declined or firms have been able to pass on much of the inflation risk.
Many Sophisticated Investors Being Swayed by Naive Research
I would like to conclude this piece with a comment on a strong push among academics and investment consultants toward low volatility investing. While the concept makes reasonable investment sense, the vital point is being missed. By failing to recognize the reasons for, or the implication behind, such a strategy’s success or failure, they are merely standing outside the five star restaurants. Stop sniffing the food and go in!
Academics have not been exposed to—nor are they remotely aware of— the risks that CFO’s face, so they are forced to rely on the tools they do know, that of naive models developed decades ago.
The concept of risk has, and will always, include metrics, both quantitative and qualitative that change over time, including new factors. Over the past five years such includes sovereign risk, derivative risk and pension risk. Other factors including management (including make-up of Board), patent loss, moral obligations, filing delays, insurance adequacy,8-K information, stability metrics, internal controls,taxes (holidays and changes to rate) or risk to the financial structure. These are ignored in favor of simplicity.
If greater sophistication were utilized, their risk portfolios would almost assuredly generate higher returns.
Kenneth S. Hackel, CFA
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