Tag Archives: sports

What Happens To ‘Hold-N-Hope’ Portfolios When An Economy Struggles To Expand?

Some analysts may dismiss 115 years of economic data. I do not. In particular, if one averages the results of four respected stock valuation methodologies, one finds that stocks are wildly expensive. Greater irrationality in stock price exuberance only existed during conditions prior to the Great Depression circa 1929 and the tech wreck of 2000. Consider the chart below. Based on the analysis by Doug Short, the widely cited Vice President of Research at Advisor Perspectives, the U.S. stock market is overvalued by 76%. It is worth noting that on all three occasions when the aggregate average approached two standard deviations above a geometric mean — 1929, 1999, 2007 — U.S. stocks collapsed by 50% or more. In addition, current valuation extremes surpass those reached in 2007. Investors should be mindful of the fact that Mr. Short does not typically offer “bearish” or “bullish” commentary. He usually provides investment and economic research, allowing others to draw their own conclusions. That said, he has served up bullet points on the high probability that market returns will be low over the next 7-10 years. Mr. Short has also mentioned that tactical asset allocation will be more important in the coming decade, as holding the S&P 500 for the next 7-10 years is likely to be “disappointing.” Keep in mind, elevated valuations in and of themselves may not provide much insight with respect to reducing risk in one’s portfolio. Years of valuation extremes can persist when other factors are at play. (Think central bank interest rate and balance sheet shenanigans.) Nevertheless, an economy that shows signs of stagnation coupled with signs of “risk-off” positioning can break the back of a stock market bull, particularly when interest rate manipulating, balance sheet expanding central banks are only running on fumes. I mentioned that the economy is stagnating and that signs of “risk-off” positioning are evident. Let me first address the economy. Corporations are not increasing their profits, as corporate earnings per share have declined for four consecutive quarters. Business revenue is even more abysmal. Companies have fallen back to 2012 levels with respect to revenue generation, and that does not even adjust for inflation. Click to enlarge Traditional retailers are struggling and some are disappearing (e.g., Wal-Mart, J.C Penney, Sears, Macy’s, Office Depot, Walgreens, Sports Authority, Sports Chalet, Aeropostale, etc.). Oil and gas? Yikes. According to reports on a Deloitte study, one-third of oil corporations may go belly up in 2016. The study focused on some 175-plus companies with more than $150 billion in debt. What about gross domestic product (GDP)? At a pace of 1% over the last six months, it is hardly expanding at all. Even the bright spot of job growth is deteriorating. Consider the Federal Reserve’s own Labor Market Condition’s Index (LMCI), which evaluates 19 unique indicators of labor market health. The LMCI peaked in April of 2014; its intermediate-moving average (6-months) peaked in August of 2014. (Note: S&P 500 earnings per share hit its all-time top in September of 2014, representing Q3 on 9/30/2014). Click to enlarge The 6-month moving average on the LMCI has not rolled into negative territory since the Great Recession (2007-2009). Before that, you’d need to look at the NASDAQ’s tech wreck and 2001 recession (2000-2002) for significant troubles in the well-being of the labor market. Does this mean that a recession is imminent? No. But it sure as heck means that labor market conditions are weakening. With “job growth” having been the one supposed saving grace in a slow-growing economy that required near 0% interest policy for seven-plus years, it seems optimism for a turnaround prior to a sell-off in risky assets would be misplaced. Of course, there are those that are keeping the faith with respect to stocks rallying well into the end of 2016 without a correction or bear. The thinking? As long as the economy muddles through, the Federal Reserve won’t be able to raise rates, and the dollar will move lower in the absence of tightening, and the lower dollar will help businesses increase their overseas sales and profitability. In other words, bad news will be good news for never-say-die hold-n-hopers. Unfortunately, there are a number of problems with the muddle-through scenario. Problemo numero uno? Household debt exceeds disposable personal income. Granted, Americans have been spending more than their take-home pay after taxes since 2001. Yet the modest deleveraging that occurred after the Great Recession has passed us by. Sooner or later, as families continue to accumulate increasing amounts of debt to spend more than they clear via disposable personal income, a retrenchment period comes to pass. Either households will be challenged in accessing credit (involuntary deleveraging) or they themselves will choose to borrow less in spite of ultra-low rates (voluntary deleveraging). Click to enlarge Economic data on consumption shows that the consumer has been softening. Bring disposable personal income into the picture, and the consumer is likely to weaken even more. The second problem for the muddle-through economy dream is the reality that “risk off” investing has been outperforming the U.S. market for 18 months already. 18 months. Consider the fact that three of the best performing assets in the 2008 systemic financial meltdown were the yen, the dollar and long-maturity treasury bonds. You could have invested in each via CurencyShares Yen Trust (NYSEARCA: FXY ), PowerShares Dollar Bullish (NYSEARCA: UUP ) and iShares 20+ Treasury Bond (NYSEARCA: TLT ). Over the last year-and-a-half, all three of these “risk-off” assets have beaten the SPDR S&P 500 Trust (NYSEARCA: SPY ). In sum, stock valuations are exorbitant, business sales are soft, consumption is strained, the labor market is weakening and “risk-off” assets are outperforming. Add it all up? There is limited upside reward for the risk one takes by remaining overexposed to equities and higher-yielding vehicles. If you normally leave 65%-70% in a diversified basket of stock (e.g., large-cap, mid-cap, small-cap, foreign, emerging, etc.), downshift to 45%-50% high quality larger-caps only. If you typically allot 30%-35% to diversified income (e.g., investment grade, cross-over corporate, high-yield, convertible, foreign, etc.), dial it back to 20%-25% investment grade only. The 25%/30%/35% that you raise in cash or cash equivalents by selling riskier assets at relatively higher prices will minimize portfolio volatility. More importantly, it will be the “dry powder” you require to buy “risk-on” assets at more attractive price in the future. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Indicators Of A Good Business

By Quan Hoang I recently had a constructive debate with my friend about the return on invested capital (ROIC). I said that we don’t calculate ROIC for fun; we calculate it to know what return retained earnings can make. High return on retained earnings means good business. He shot back that See’s Candies has little volume growth and it’s still a good business. His point led me to the broader topic of what a good business is. In a nutshell, a good business can create value. In other words, it can generate more than 10 cents for each $ of earnings it retains – assuming a 10% hurdle rate. But there are special cases in which a company can make more profits by retaining zero or negative earnings. Exceptional Businesses Have Negative Invested Capital or Pricing Power One special case is negative invested capital. Omnicom (NYSE: OMC ) is a good example. It pays for advertising spaces slower than it bills clients. Working capital is about -20% of sales. The negative sign means that Omnicom gets 20 cents pre-funding from clients for each additional $ of sales. If growth is stable, a business with negative invested capital deserves a higher than average multiple of EBIT. Another special case is exceptional pricing power. See’s Candies has exceptional pricing power. From 1972 to 1998, See’s Candies raised price per pound by about 6.9% annually. Inflation over this period was about 5.4%. So, pricing power generates about 1.5% real growth each year. That leads to margin expansion. This magnitude of pricing power is rare because the product becomes more expensive relative to a customer’s purchasing power over time. That’s not sustainable in most cases. But See’s Candies has been able to do so for many years. Another good example of pricing power is luxury Swiss watches. Swiss watchmakers managed to reposition mechanical watches from a utility product to an emotional product. But after that repositioning, it’s difficult to raise price faster than inflation. To do so, a brand must move upmarket and become more exclusive. Omega, on the path to regain its past prestige, has raised price from Longines’s price range closer to Rolex’s price range. Without exceptional pricing power, value is normally created through volume growth. Volume growth normally requires additional investment in production/service capacity and working capital. Value is created only if return on investment is high. How to Calculate ROIC A practice that many analysts use is to say that a business is good if it consistently make a high ROIC. Joel Greenblatt’s formula for ROIC is EBIT/NTA. NTA is N et T angible A ssets, which is the sum of net fixed asset and net working capital. There are several versions of ROIC. But all versions use net fixed assets in calculating the denominator. And that creates some controversies. Joel Greenblatt explained why he uses net fixed asset: Why are we taking Net Fixed Assets (NFA)? It is not always right. Say we buy a hotel for $10 and it is going to last 10 years and we write it down over 5 years and now it is at $5. But if this goes down to zero, I might have to invest another $10. This would give me ($5) a skewed return (being too high) because of not considering replacement and reinvestment into the fixed assets. Say you have 100 hotels and they are all on different cycles, then on average, you will be correct in using NFA. 10% of your hotels will be refurbished each year over a 10 year normal cycle. That is my quick and dirty for an ongoing business.” And, Denominator is NWC + NFA – why using net and not gross fixed assets? On average that is the right thing to do. Because in general what happens to your fixed assets, you buy something and you depreciate the assets so the value of your asset goes down, but to maintain your asset, there has to be on-going capex. Depreciation and Capex cancel out (assume Deprec = Maint. Capex). If capex is more than depreciation, then FA will increase accordingly and you will be updated. If you are in expansion mode, you build new stores and the FA balloon before you earn on those assets, so your ROC will decline – so you must normalize or adjust for that. Fixed Assets minus depreciation plus Maint. Capex is why I use a Net number.” There’s some logic in his argument. But he didn’t examine how accurate EBIT/NTA is as a measure of ROIC for an ongoing business. If we own the 100 hotels in his example, we get cash flow roughly equal to EBITDA each year (assuming no tax). 10 hotels are totally depreciated each year. We can choose not to make any refurbishment at all and let EBITDA decline by 10% next year. We can refurbish 10 hotels and maintain EBITDA. Or we can refurbish and build 10 more hotels to grow EBITDA by 10%. In either case, ROIC of each new build or refurbishment will be based on the $10 gross investment in each of these projects because that’s what we have to spend upfront. Let’s take another example. The Fresh Market (NASDAQ: TFM ) spends about $4 million in a new store, which generates about $10 million sales and $1 million EBITDA. TFM remodels its stores every 10 years. The remodel cost is lower than $4 million in real term, but let’s assume the remodel cost to be $4 million. So, annual depreciation is $0.4 million and EBIT is $0.6 million. A very optimistic assumption is that the store requires no remodel. So, the $4 million upfront investment results in $1 million annual cash flow forever. That translates into 25% annual return (25% = ¼). Realistically, there’s remodel cost every 10 years. So, 25% is the ceiling of ROIC. Generally, ROIC is always lower than EBITDA/Gross NTA. (Gross NTA = Gross fixed assets + Net working capital.) A very conservative assumption is that we set aside “DA” each year. In the TFM example, we set aside $0.4 million each year so that after 10 years we have $4 million to spend on remodeling. That way, we’ll have $0.6 million free earnings each year (the “free” part is borrowed from the term free cash flow). So, the $4 million upfront investment results in 15% annual return (15% = 0.6/4). Realistically, we don’t set aside $0.4 million each year but use that money to fund new store openings. So, 15% is the floor of ROIC. Generally, ROIC is always higher than EBIT/Gross NTA. If we open Excel and calculate IRR for various scenarios, we can see that IRR tends to be in the upper end of the range between EBIT/Gross NTA and EBITDA/Gross NTA. The midpoint of the range is quite a good estimate of ROIC. Using EBIT/NTA is dangerous when fixed assets are a big part of NTA. I made that mistake when I first looked at Town Sports International (NASDAQ: CLUB ). Median EBIT/NTA was 20%, which looks good. But median EBIT/Gross NTA was 9% and median EBITDA/Gross NTA was 19%. So, pre-tax ROIC is around 14% instead of 20%. That’s a mediocre return. We must be flexible when estimating return. We have to look at composition of NTA. It’s okay to use EBIT/NTA when PPE is a tiny part of NTA because the error is small. If PPE is a big part of NTA, using the midpoint of EBIT/Gross NTA and EBITDA/Gross NTA is preferable. If receivables are a big component, we should make adjustments. For example, America’s Car-Mart (NASDAQ: CRMT ) has $324 million receivables, $34 million inventories and $34 million PPE. However, Car-Mart doesn’t really lend money. Car-Mart lends cars. So we should adjust receivables to (1-gross margin) * receivables to estimate the total value of the cars it lend and use that number to calculate NTA. A better method to estimate ROIC is to look at the economics of each loan. Return on Incremental Invested Capital (ROIIC) What we really want to know is ROIIC rather than ROIC. We can calculate ROIIC by taking incremental EBIT or EBITDA over incremental invested capital over a 1- to 3-year period. That’s not a good approach. Sometimes a company has excess capacity, so growth doesn’t require fixed investment for a while. Or sometimes a company has excess working capital and it can take capital out. But these examples are short-term adjustments. In the long run, volume growth requires investment in new production/service capacity and in working capital. So, ROIC is a good starting point to estimate long-term ROIIC. Reinvestment in the same business tends to achieve returns similar to past ROIC. That’s why many businesses have ROIC within a certain range. However, we need to make some adjustments to ROIC to have a fair expectation of ROIIC. Margin expansion can make ROIIC higher than ROIC. Margin expansion is usually a result of volume growth that drives down unit cost. For example, when gross margin is high and SG&A is relatively fixed, volume growth will significantly increase EBIT margin. Tom Russo usually uses Brown-Forman to illustrate the concept of the capacity to suffer. Brown-Forman is willing to incur expenses today to build infrastructure for international growth tomorrow. And the next 50,000 bottles it sells will have better margin than the last 50,000 bottle. Frost (NYSE: CFR ) is another good example. Frost’s branches grow deposits faster than inflation. So, operating expenses per $ of deposit declines over time. Gross margin in the banking industry is net interest spread. Net interest spread is influenced by interest rates and demand for loans. It’s cyclical but very stable over a long period of time. So, lower operating expenses per $ of deposits improve ROA. Today, Frost makes lower ROA than it did in the past. But without the impact of low interest rates, Frost should be able to make much better ROA. We must be careful when volume growth is outside of current goodwill. In such case, high ROIC in the past doesn’t guarantee a high return on reinvestment. See’s Candies wasn’t able to grow profitably in other states because it failed to replicate the mindshare it had in California. TFM is a current example. TFM is a gourmet food chain. Consumers shop at traditional grocers most of the time. But in some special occasions, they may go to TFM for very good foods. Consumers on average go to TFM only once a month. TFM wants to be the first choice retailer for “special.” So, unlike other grocers, TFM relies on mindshare instead of habit. TFM is very strong in the Southeast. It got into trouble in recent years when it expanded into new markets. It’s very difficult to create mindshare in a totally new state. But perhaps it’s easier to open the next store in that state because the first store helped build some awareness and word of mouth. Conclusions The term “good business” is perhaps too broad. A firm that achieved high growth and great return but have little growth potential in the future isn’t as good as its past success suggests. Firms that barely made profit in the past might now be done with the investment phase and will enjoy great profitability in the future. What investors care about is perhaps more specific: a good business to buy. I propose 3 indicators of a good business to buy. The first is negative invested capital. The second is exceptional pricing power. The third is high ROIC. Past ROIC is a good benchmark for ROIIC. But to have a fair expectation, we need to consider other factors like whether margin of additional units will be higher and whether volume growth is inside current goodwill. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.