A 2010 equity portfolio: the current “exogenous” event

Exogenous shocks

Economists explain the depth of the recessions of 1973-74 and 1980-1982 by pointing to extraordinary shocks to the world economic system that occurred during these periods.  In both cases, the shock involved was a sudden two-or threefold rise in the price of oil in economies very dependent on petroleum.

The current case

In the case of the current financial crisis, the “shock” was the sudden collapse in 2008 of major international banking firms in the US and the EU.  The reason?  –the realization that trillions of dollars of exotic securities that commercial and investment banks created, owned in very large size (and therefore counted as an integral part of their capital) and traded with one another were pretty much worthless.  As a result, many of these financial institutions were essentially bankrupt.

The housing problem

What triggered the crisis?  Many of these “toxic” securities were based on home mortgages taken out by “sub-prime” borrowers, who by and large didn’t have the income to make their mortgage payments.  These borrowers began to default.

What separates the current housing bubble from previous ones is the duration, and consequently, the size of the lending to unqualified borrowers.  Fed money policy in the US was unusually loose (see my June 3, 2009 post in Odds and Ends reviewing  John Taylor’s book on the crisis, Getting Off Track) for several years at the start of the decade. Government and trade groups estimate that:

–over 10% of outstanding mortgages were given to unqualified buyers,

–one in four residential housing commitments were made to speculators, vs. one in ten during a “normal” boom, and

–for a quarter of current mortgage holders, their home is worth less than the mortgage amount they owe.

Other, related, problems

Bad credit and weak banks aren’t the only problem.  the booming housing market signaled continuing economic prosperity.  So housing and commercial construction companies expanded and hired more workers, as did materials suppliers, retailers, hoteliers, airlines–and just about every other economic entity in the US.  When the bubble burst, we found ourselves with an economic infrastructure that is 5%-10% too big for what we can use.

The crisis also underlined the poor state of government finances in Washington, weakened by the Bush administration’s policies of increased social spending and tax cuts, while also waging an expensive war in the Middle East.

Derivatives allowed US problem loans to be exported to Europe and infect the banks there.  France was a hotbed of “financial engineering” expertise, which helped the process along.  The fact that most transactions originated in London, where laws differ from those in the US and where regulatory supervision was lax, poured gasoline on the fire.

Two low points

1.  In September 2008, Secretary of the Treasury Paulson decided to allow the investment bank Lehman Brothers to go into bankruptcy.

This had two immediate unintended effects, which both spread the financial crisis far beyond the housing market.  International trade finance, and therefore the lion’s share of international trade, immediately dried up on intensified concerns over counterparty risk (if Lehman could fail, who was safe?).  Also, worries about counterparty risk spread to money market funds, some of whom had bought Lehman short-term debt to try to raise their yields.  As investors shifted to federally-insured bank deposits instead, they all but eliminated an important source of working capital finance for American industry.

During this time, industrial layoffs intensified.  Armed with sophisticated supply chain management tools, companies could see the full extent of the economic contraction that the crisis was bringing.  Many also realized they had made a mistake during the 2000-2002 downturn by not cutting production–and workforces–quickly enough.  So they cut very sharply this time around.

2.  In March 2009, sentiment reached its lowest ebb when Congress initially refused to appropriate funds for a bailout of the financial system.  For a while, the world feared that the global financial system would collapse, bringing on a new version of the Great Depression of the 1930s–not because the problem, although large, was not understood or was too big to handle, but because of cognitive/intellectual deficiencies among myopic US legislators.

The repair process

A lot of positive things have happened since the darkest days of nine months ago.  The repair process will be the subject of my next post.

A 2010 equity portfolio: two types of recession, two types of recovery

Two types of recession

Looking at recessions in a very simple way–but good enough for our purposes–economist divide them into two types.

1.  The garden variety starts when the economy is growing at a faster rate than the central bank thinks it should.

This means different things in different countries.  In the EU, for example, excessive growth means a rate of expansion that contains the slightest risk of inflation.  In the US, in contrast, the Fed’s job is to encourage maximum sustainable GDP growth, with acceptably low inflation–meaning in today’s world a maximum of 2%.  Let’s consider the US case.

When the economy has expanded to the point where there is very little unused labor, firms that want to expand begin to offer large wage increases to lure workers from other companies.  This wage competition–by raising the overall level of salaries–creates the threat of excessive inflation.

The Fed reacts by raising interest rates to slow the expansion down.  After six months to a year, seeing it has created some slack in the labor market and that the economy is dipping below its growth potential, the Fed begins to reverse course and lower rates again.

2.  The less frequent, but deeper and longer, recessions may have all of the elements of the garden variety business cycle type, including the central bank’s raising rates to attempt to fight inflation.  But the real defining characteristic of the deeper recessions is what economists have called an exogenous event, or an external shock. In the case of the deep recessions of 1973-74 and 1980-82, the external shock involved was the negative effect of an almost-overnight tripling in worldwide oil prices on industrial economies deeply dependent on petroleum.

Two types of recovery

Recovery from the garden variety recession is straightforward.  The central bank, which created the slowdown by adjusting short-term interest rates upward, moves them back down again and the economy gradually picks up speed.

Recovery from deeper recessions is also straightforward–elimination of the causes of the economic slowdown.  But it’s harder to accomplish, and takes longer to achieve, because it involves structural adjustment to a new set of economic realities.

The 2007-2009 recession

The very deep recession which has just ended doesn’t appear at first to fit neatly into the “external shock” category.  There are two reasons for this:  the commodity whose supply/demand characteristics has changed is money; and the source of the systematic shock is not a far-off and exotic land, but the center of the western financial world, the US and the UK.

Nevertheless, as was the case in other deep recessions, recovery in this instance, too, will consist both in adjustment to the new economic realities and in repair of the damage done by having assumed that the old “business as usual” would go on forever.

That’s it for now.  In my next post, I’ll try to spell out the specific recovery issues we now face.

A 2010 equity portfolio

Over the next week or so, I’m going to write a series of posts about the shape I think a portfolio should have for 2010.  The yshould come in the following order:

–the likely course of the US economy in the new year,

–the current state of the stock market,

–what I think the consensus opinions about 2010 are, and

–(most importantly) where I think a portfolio should differ from the consensus in order to perform better than it.

At this point, I don’t have very strong opinions.  But I’ve always found that I begin to form them when I approach the issues in writing.  I hope that will happen this time as well.

There are some general conclusions that I think we can draw, though, even before more careful analysis.

1.  Certainly, there’s no reason I can see to expect that 2010 will be more emotionally trying than 2009 was.  At the same time, 2010 stands to be a more difficult environment to make money in, in the sense that the chance to profit from the panic of the first quarter of 2009 is unlikely to recur.

2.  The average yearly return in US$ on the S&P 500 has been about 9%-10%.  Another rule of thumb is that returns will be inflation + 6%.  I think it’s reasonable to ask whether you think returns will be higher than average in 2010 or lower. My answer would be higher.   Why?

We are in the early stages of recovery from a very bad recession that ended only a few months ago.  Stocks, which had been falling precipitously for almost two years, have been rising for about nine months in anticipation of renewed economic growth.  Upward trends like this typically last for at least two years or more.  Maybe this time will be different, but betting that this sort of history won’t repeat itself is almost always a losing one.

3.  Very large amounts of money remain on the sidelines in money market funds (which yield close to nothing).  Individual investors also appear to have switched large amounts of money from stocks to bonds–where they are very exposed to losses as and when interest rates begin to rise.  In prior market cycles such money has sooner or later reentered the stock market.  I expect the same will occur this time around.

4.  Invariably the Wall Street consensus is wrong about how the economy and the stock market will develop.  That’s not anything new.  It’s never 100% incorrect, however–no one’s perfect.  The real trick for an investor is to try to figure out how the consensus will be off the mark and to concentrate one’s bets against the consensus only in that area.

Remember, too, we don’t need to have opinions about everything.  In fact, we don’t want to have opinions about everything. We want, instead, to have a few well thought out opinions (even one really good thought will do) that are away from the consensus thinking and where our own research tells us there’s a very high probability that we’re right.

Working Capital: cash and short-term investments

Many observers have remarked that accounting techniques can give favorable shadings to almost every balance sheet or income statement entry–but they can’t do anything about cash.  Therefore, they conclude, analyze the changes in cash and you can most accurately assess the strategy a company is taking and the profits a company is making.

Analyzing cash as a component of working capital

I think this is right, but analyzing cash–which means looking at the sources and uses of funds–is a little more complex than just looking at the “cash” item in Current Assets.  For working capital purposes, though, there are only a few things to look for to make sure you get an accurate picture of the changes, + or -, in the cash a company is holding:

Three rules

1.  Count all the cash.  Cash in a checking account (cash) and T-bills (short-term investments) will certainly appear in Current Assets.  But if the company has cash it knows it won’t need for a while, it may also buy Treasury securities that mature in more than twelve months.  They’ll be in the long-term section of the balance sheet, as Long-Term Investments.  Count them, too (you may have to check the footnotes to the balance sheet to make sure the company hasn’t mixed in equity holdings in joint venture projects, or other “real” investments that shouldn’t be counted as cash.).

2.  Look for a buildup in financial liabilities and subtract it, if there is one.  Check for increases in payables and short-term debt and long-term debt.  Also make sure there hasn’t been an equity issue.  All of these items will generate cash, but adding liquidity from new debt or new equity isn’t the same as adding it from operations.  It’s highly unusual for a company to issue a special cash dividend to use up extra cash (WYNN is the only firm I’m aware of to do so recently), but you might look for that and add it back in.  Personally, I wouldn’t add back in stock repurchases, although firms present these as a “return” of cash to shareholders, since they typically only offset (as well as disguise) the company’s issuance of stock to top management.

3.  Think twice about negative working capital companies.  When negative working capital companies have increasing sales, they generate excess cash, just due to the fact that customers pay for the product/service either in advance or before the company has to pay its suppliers.  Often, these companies will use the excess cash to fund capital expenditures, believing that they will continue to grow and generate larger amounts of cash.  That’s the highest probability case.  But there’s always the risk that revenues will stagnate, or even begin to decline–in which case the business will begin to absorb cash rather than throw it off.  One adjustment for the cash position of negative working capital companies would be to calculate payables minus receivables and subtract the difference from cash.

Working Capital: inventory


Inventories are either a very complex topic or a very simple one.  I’m taking the simple route here.

One ratio:  inventory/sales (or sales/inventory)

There’s only one ratio that securities analysts are interested in:  inventory/sales. As with other working capital items, one could also calculate inventories/cost of goods, but I don’t think that using this less common ration gets materially different results.

What the ratio means

The significance of the ratio is what one would expect–it’s bad if the ratio of inventory/sales starts to go up vs. historical experience.

Two cases

In looking at inventories, it’s important to distinguish two cases:  manufacturing companies, which create products or services, and distribution companies, which add their value by selecting among products of manufacturers and making them available either to other distributors or to end-user customers.

1. Manufacturing companies. For a manufacturer, inventory is classified into three categories:

–raw materials,

–work in process, and

–finished goods.

You’ll probably be able to get additional information from examining the percentage of total inventory contained in each category, but normally looking at the overall inventory total will be good enough.

A rise in the inventory/sales ratio usually represents an unanticipated slackening in demand for products contained in the finished goods inventory.  The falloff can be the result of a general economic slowdown, the emergence of new competition, or something wrong with the product itself.

(Note: while an unintended rise in inventories is a bad thing, a 15% rise in the dollar amount of finished goods doesn’t mean there are 20% more items in the company’s warehouses.  For example, assume the company has factory costs of $1 million a quarter that it allocates over full-capacity production of 1 million units.  That amounts to $1 per unit.  If the variable costs for each unit are $1, then the total cost per unit will be $2.  If nothing is sold during the quarter, the total dollar amount added to inventory will be $2 million.

If the beginning inventory is 5 million units and $10 million, then the ending inventory is 6 million units and $12 million.

Now suppose instead that the company responds to order cancellations by cutting current-quarter production in half.  That means it makes 500,000 items at a variable cost of $1 each.  It allocates $1 million of factory costs of those items at a rate of $2 each.  So total cost per unit is $ 3.  Ending inventory is 5.5 million units and $11.5 million in value.  In this case, the dollar value of inventory has gone up by 15%, but total units are only up by 10%.)

2. Distribution companies (think: Amazon, Advance Auto Parts or a supermarket).  Distributors are typically low-margin, high inventory turnover businesses.  They may have considerable value imbedded in their brand names, the know-how that produces their logistics computer systems and their physical store locations.  But these positive attributes do not often manifest themselves in high operating margins.  As a result, because they do not have the high margins of companies with significant legally-protected intellectual property, some growth investors tend to underestimate their earnings expansion potential.

Distributors’ claim to fame rests in their ability to turn inventories quickly.  For this reason, analysts usually place a lot of their analytic efforts on inventories, which they talk about in terms of “turns,” that is, annual sales divided by average (or some other measure to smooth out seasonal variations) inventories.

Since distribution companies usually don’t have exclusive rights to sell unique products, the sales/inventory ratio–how many times it can “turn” inventories in a year–is a good standard of comparison across competitor distribution companies, as well as for comparing a firm with its own history.

For a strong distribution company, sales should rise faster than inventory.  Therefore, inventory turns should rise over time.

Any deterioration of the pattern, either a flattering out of turns or a decrease in turns, is a cause for concern.  On the other hand, an increase on turns, or even better, an acceleration of turns, is a very bullish sign.

Working Capital: payables

Accounts payable

Accounts payable, or simply payables, are the trade credit that is extended to a company by its suppliers.  Payables are liabilities, things the company owes to others.  In almost all instances payables are current liabilities, and, as such, part of working capital.  There are rare instances, however, where they are long-term liabilities.  I gave an example of oilfield service company behavior after the mid-Eighties collapse in energy prices in my post on receivables.  The corresponding item to the long-term receivables on the oilfield service balance sheet would be the long-term payables on its customers’.

Two ratios

There are two payables ratios of primary interest to a securities analyst:  payables/sales and payables/receivables.  Both are calculated using the payables and receivables figures taken from the balance sheet of a certain date.  The sales figure used is for the twelve months ending on the balance sheet date.

The ratios are compared, first and foremost, with a company’s own history.  But since a supplier normally provides customers with more or less standard raw materials on more or less standard payment terms, it is also reasonable to compare the payables to sales ratios among different firms in a given industry.  The results will give a first approximation for the relative market strength and relative bargaining power of industry participants.

1.  receivables/payables. Receivables/payables is a way of quantifying the relative strength of a company vs. suppliers and customers in the universe it operates in. In a CEO’s ideal world, customers would be so eager for the company’s products that they would pay in cash–or even in advance (therefore, no receivables)–and suppliers vying for the privilege of supplying the company would provide unusually long payment terms (big payables).  In CEO hell, on the other hand, suppliers would be so worried about the financial viability of the company that they would demand payment up front (therefore, no payables) and customers would take the finished product only if they could obtain (a la Chrysler) unusually generous financing (big receivables).

As a general rule, the bigger the number, the weaker the position of the company in question.  It’s also important to examine the historical record.  Is this ratio constant over time, or has it recently begun to signal strength or weakness?

Look at the raw numbers, too

In addition to looking at the ratio, you should look at the raw numbers as well–and in two ways.  First, consider how much of the overall credit extended to customers by a company is in effect being financed by credit it is receiving from suppliers.  Then look at the increase in receivables over the previous, say, three years and compare that with the increase in payables.  Do the competitive dynamics of the company’s industry allow the company to keep any of the benefit of increased credit from suppliers?  or has the company been forced to simply pass this financing benefit on to customers?

2.  payables/sales Decline in this ratio can be a very important early warning sign of impending trouble for a company.  Suppliers are constantly analyzing the prospects of all their customers.  Because they deal with a wide variety of firms in their targeted industries, and because they see the pattern of their customers’ payments for supplies, they possess a very sophisticated picture of the industry and each company’s place in it.

Trade creditors are also at the bottom of the pile when it comes to recovery during liquidation.  So they have a lot to lose if they continue to send materials to a failing customer.  As a result, shrinkage in payables is a very reliable indicator of potential trouble.