auto companies and their financing affiliates

Last Friday the Wall Street Journal reported that Ford is going to use new measures of creditworthiness beyond FICO scores that will allow it to approve loans to borrowers now considered too risky to provide financing to.

 

One of the reasons I’ve rarely owned auto company stocks is not just that they’re highly cyclical.  I (hope I) can deal with that.  Rather, it’s it seems to me that, invariably, as the car-buying cycle matures, operating and sales executive put pressure on the captive lending arm of the company to make riskier and riskier loans.

This happens it two ways:  more liberal lending policies; and increasingly optimistic assessments of the resale value of leased cars (called residual value) when they are returned at the end of the lease.

The poster child for this type of behavior is Mitsubishi Motors, which tried years ago to jumpstart US sales through a “triple-zero” sales campaign.  It offered loans with no down payment, 0% interest and no payments for the first year.  The campaign produced an unwanted fourth zero when virtually no one made loan payments when required–and the firm only avoided bankruptcy through a Japanese style rescue by the less-than-pleased other members of the Mitsubishi industrial group.

 

Generally speaking, the PE multiple for companies whose earnings are very cyclical tends to contract as the cycle nears its peak.  For auto firms, and other companies with similar in-house financing operations, this contraction is especially severe because investors fear that too-generous financing may boost sales today but be offset by big writeoffs in a year or two.  Because of this, investors are not willing to pay for what they regard–historically, correctly–as artificially inflated results.

Maybe Ford will be different this time, but my guess is that investors will at least initially regard results with skepticism.

 

 

21st century retailing: my trip to Home Depot

This is another mountain-out-of-a molehill thing.

We have Toto toilets in our house.  Toto is the leading brand in Asia and has been making significant inroads in the US over close to two decades.  Yes, they’re the toilets that play music, heat the seat, double as a bidet and make fake urinating noises (a Japanese must)–but we just have plain old toilets.

The other day, I went to the local Home Depot, which, by the way, sells Toto toilets, to get a replacement part for one of ours.  A friendly employee showed me where the replacement parts were–all aftermarket brands, not Toto, but that was ok with me–and which was the right one. The replacement didn’t look much like the broken part, but the employee assured me that it would work.

It didn’t.  And, in fact, in looking back on my trip, the HD employee may, strictly speaking, have only told me that that was all they had.  If so, kind of embarrassing for me, since for most of my working life I was on the alert for verbal gymnastics aimed at papering over problems.

Rather than launch a telephone search for a plumbing supply store in the neighborhood that might carry the part I needed, I found it on Amazon.

 

Around the same time, I found I needed a replacement part for a Weber grill.  Same story.  HD sells Weber grills, but not replacement parts.  So, after a wasted trip to the local HD store, I ordered from AMZN.

 

What’s interesting about this?

In the early days of the internet, there was lots of speculation about the “long tail,” meaning that e-retailers like AMZN would make most of their money from selling obscure items that potential buyers couldn’t find in bricks-and-mortar stores.

A great story   …just not the case back then.  Just like bam, online exhibited the “heavy half” phenomenon, i.e., 80% of the business came from 20% of the items.

 

But maybe the long tail is beginning to come true.  It’s not because weird stuff that no one really wants has suddenly come into vogue.  Instead, I think computer-driven inventory control programs that eliminate slow-moving items from a store’s offerings may have gone too far.  Yes, carrying fewer items has the beneficial effect of requiring fewer employees and less floor space.  But at some point, the process begins to have negative consequences, as well.

For instance, it’s training me not to go to a physical DIY store, so I’m not passing by enticing end cap displays or being tempted by the sparkly high-margin junk arrayed along the checkout line.

 

My experience as an analyst has been that any cost-control measures always seem to go too far.  They work for a while, but the continual application of the same process somehow eventually ends up creating the opposite of the intended effect (yes, experience has made me a Hegelian, after all).  This may be what is starting to happen with inventory control programs that retailers use.

If I’m correct, this is another plus for AMZN.

 

Jim Paulsen on the US stock market

Yesterday’s Financial Times contains a guest column by Jim Paulsen, strategist for Wells Capital, a part of Wells Fargo.  I find Mr. Paulsen’s work to be orignal, thoughtful and, for me, thought-provoking.  On the other hand–a warning–he and I share the same generally optimistic view on markets and have tended to agree on most basics.

Here’s what he has to say:

–the current market swoon may have been triggered by worries about the Chinese economy, but its real cause is to be found in the dynamics of the US economy/stock market

–US stocks were, and still are, trading at an unsustainably high price-earnings multiple.  The final bottom for stocks in this correction will be around 1800 on the S&P 500, or about 3% below the low of a few days ago.  That’s where stocks will be on a more reasonable 15x PE

–full employment in the US, i.e., where we are now, creates a series of problems for the economy and stock market.  Employers wishing to expand are forced to find new workers by bidding them away from other firms.  Since inflation in advanced economies is all about wage increases, poaching creates inflation.  In the short term at least, a higher wage bill means lower margins–and therefore lower profit growth.  The Fed responds to the inflation threat by raising interest rates, which exerts downward pressure on PEs

–investors don’t get this yet.  They’re “more calm and confident than at any other time in this recovery.”

–the combination of high PE, higher interest rates and slowing growth mean that equity investor focus will shift from the US to more fertile fields abroad.  These areas are more prospective because, unlike the US, they don’t face the need, caused by achieving full employment, to rein in the pace of domestic economic growth. I presume, although Mr. Paulson isn’t more specific, that this means the EU (it may also mean US stocks with high exposure to non-US economies).

my thoughts

Mr. Paulsen is in touch with institutional equity investors every day.  So he has a much better sense of the current thought processes of US professionals than I do.  He seems to feel his customers are only beginning to believe that the set of issues that come with full employment are at our doorstep–and are only now starting to discount them into stock prices.  Hence the correction.  While it’s risky to think you know more than the other guy–in this case, that the other guy slept through his elementary economics classes–I’m willing to go along and say it’s true.

Mr. Paulsen has previously made the point that interest rates are going to rise in an economy that doesn’t have much business cycle oomph left in it.  Therefore, he argues, past instances of cyclically rising rates, during which stocks generally were flat to up, may not be good guides to what will happen today.  I look at the situation in a different way.  If we ask where long Treasuries will be at the end of Fed tightening, the answer is that they’ll likely be yielding less than 4%.  If we think that the yield on Treasuries and the earnings yield (1/PE) on stocks should be roughly equivalent, then the implied PE on the S&P is 25x.

One might argue that the idea of the equivalence of earnings yield and interest yield arises from a long period in which Baby Boomers preferred stocks to bonds.  As Boomers have aged, that preference has reversed itself, meaning that yield equivalence between stocks and bonds may be too rosy a view for stocks.  If we assume that stocks trade at a 20% discount to this yield parity, however, the implied PE at the end of rate hikes is still 20.

Both results are a long way from the 15x that Mr. Paulsen proposes for the S&P.

It’s often the case that a significant drop in stocks often signals a leadership change.  I think it makes a lot of sense to reverse portfolio polarity away from an emphasis on earnings coming from the US to profits generated abroad.  How exactly to carry this idea out is the key, though.

 

 

the inventory problem: holding costs vs. stockout risks

The domestic auto industry reported November vehicle sales yesterday.  The numbers were very good.  But most of the (negative) media attention centered on the elevated level of inventories–about three months worth of sales–on dealer lots. Yes, that may eventually be a worry, but I don’t think it’s the right way to look at the current situation.

The auto news also gives me the occasion to write about the balancing act every manufacturer and retailer faces in deciding how much inventory to have.

the simplified story

There’s an often convoluted dance between supplier and distributor/end user about return policy, payment terms, co-op advertising…in negotiating over how much of a product to buy and at what price.  Nevertheless, the decision about how much inventory to hold ultimately comes down to weighing two opposing risks:

stockout costs.  This is when your brilliant national advertising campaign, your sterling reputation for high quality and service–or sometimes just random factors–prompt a potential customer to either go online or enter a physical store with the intention of buying an item.

You’re out of stock.  You try to interest him in a substitute, or promise to have the item tomorrow.  He says thanks, leaves and buys the item somewhere else.

You’ve lost a sale.  And the person you’ve disappointed is at least marginally less likely to have you first on his list next time he’s shopping.

That’s stockout costs.

inventory holding costs are much more straightforwardly quantifiable.

There are three main factors:

-financing costs, which in today’s world are negligible;

-liquidity risk of having your capital tied up in inventory rather than in cash during the time it tales you to make a sale; and

-the possibility that the items either become obsolete, go out of style, or–like fresh food–exceed their shelf life before they can be sold.  Then your asset has become a wirtedown.

complications

(In the stock market, there are always complications.)

In good times, companies want to hold more inventory (because they see stockout as a greater risk than holding costs); in bad times sentiment reverses and everyone wants to hold as little as possible.

If prices are rising, procurement managers see the chance to make windfall profits and order more than they need; if prices are falling–as is chronically the case in industries like consumer electronics–inventories are kept trimmed to the bone (except in really good times, when everyone throws caution to the winds).

In industries with low fixed, high variable costs, manufacturers see no percentage in upping production volumes.  In industries like autos, with high fixed costs and therefore tons of potential operating leverage, there’s a tremendous incentive to make extra units once a firm reaches breakeven.

The competitive structure of an industry doesn’t change the nature of inventory risk, but it can change who it is who’s assuming them.  This may not always be obvious from even a detailed study of the working capital sections of the balance sheet.  If a manufacturer were to have a policy of unlimited returns (that would be crazy, but let’s just suppose), then it–not anyone farther down the distribution chain–would ultimately be responsible for any unsold goods.

 

More tomorrow.

 

 

 

 

 

economic/stock market cycle: 4 years or 8?

phone call from sunny CA

My younger son called the other day to talk about the stock market.  He reminded me that I had often spoken as he was growing up about the four-year stock market cycle seen in the US.  It’s sometimes called the presidential election cycle, from the belief that the sitting president injects PEDs into the economy in the fourth year of his term to aid his reelection bid.  It’s also called the inventory cycle.

the traditional four-year market cycle

The idea behind this is that in the post-WW II US the typical period of business cycle expansion, during which government policy is to stimulate growth, has lasted about 2 1/2 years.  As we reach full employment and upward wage pressure commences, the policy stance reverses.  Interest rates rise; the economy slows–and sometimes contracts.  This latter period lasts around 1 1/2 years.

The stock market exhibits the same behavior–2 1/2 years of up followed by 1 1/2 years of down–but leads the economy by about six months.

a rule of thumb

The four-year cyclical pattern generates a practical rule for investors:

–when the stock market has been rising for two years, start thinking about becoming more defensive, and

–when the market has been falling for a year, think about becoming more aggressive.

the eight-year cycle

The point of my son’s phone call is that this traditional pattern can’t be found in charts of market action for almost two decades.  It has been replaced instead by an eight year cycle–5 1/2 years of up, followed by 2 1/2 years of down.  More importantly, two months ago, we entered the fifth year of rising market.

His conclusion from looking at the charts:  early in 2014 the S&P will hit the skids.

 

This is a very interesting thought, even if it turns out not to be correct.  It makes you stop looking the leaves on individual trees and start to think about the shape of the forest as a whole.

differences?

Is the stock market situation today substantially different from the tail end of the internet bubble of 1999, or of the emergence of the mortgage fiasco/financial crisis of 2008?  If so, what are those differences?   …can we conclude that today’s story will end up any better than those two did?

I think there are key differences.

More about this on Monday.

 

 

using days sales to measure inventory: a dangerous method

an example

I started out on Wall Street as a securities analyst covering the oil industry during the oil and gas boom caused by the second OPEC “oil shock” of 1978-80.  The sharp rise in prices (which today looks a bit ludicrous) from $7 a barrel to $14–implying a spike in gasoline prices above $.50 a gallon!!!–caused a huge increase in drilling for new deposits.

One key shortage element was the steel pipe used to line the well hole already dug, to prevent the hole from collapsing in on itself.  Without steel pipe to line the well you couldn’t drill.  So one of my standard questions during the interviews I did with company managements as I was preparing to write evaluations of their stock prospects was how much steel pipe they had on hand.  It was usually only two or three months’ worth.  It was never enough.  And the makers of the pipe were never able to ramp up capacity fast enough to meet demand, no matter how fast they put up new plants.

Anyway, one day I was talking to the CFO of a small exploration company in Texas.  When I had last talked with him, a couple of months before, he had said his company had about two months’ worth of pipe on hand.  I asked the question again.  He said, “We have a year’s worth of pipe on hand.”

I said, “You must have finally gotten a big shipment in.  How did you do it?”  He replied. “No.  Our drilling plans have changed.”

This was my first concrete indication that the commodity bust, which often follows a big boom, had arrived in the oilpatch.  What the CFO in my story meant to say was that prices had already fallen to a level where the wells his firm had been planning to drill were no longer economical and he could no longer get financing to carry out the projects.

the cash conversion cycle

This is a measurement of how much cash a company needs under current conditions to turn a dollar invested in working capital to make a new product back into cash.  It’s the sum of three parts:  the time it takes from purchasing raw materials until the sale of a final product is made + days credit extended to purchasers – days credit extended by suppliers.

In most cases, the key time element is the first element, the time in inventory.  Hence, the focus on inventory days.

supply and demand is much more important

…as my oil company example shows.

housing

Just as the situation of extremely constrained inventories can prompt one to draw the misleading conclusion that conditions will always be tight, the situation where inventories are massive can also be deceptive.  Housing in the US may well be a current case in point.

Despite the evidence that the housing market has been picking up in the Us for the past year, until just the past two or three weeks media reports have been strongly biased to the negative side.  One of the key figures being cited is the large inventory of unsold homes available for sale.

Two elements are wrong with this analysis, in my view:

–after many years of languishing on the market, and presumably not being maintained, I think it’s questionable whether all the dwellings counted in that inventory number are actually salable.  Maybe a quarter aren’t.

–even small changes in demand can make large differences in the days- sales measure.  For example, the latest Department of Commerce figures show that the inventory of new homes available for sale in the US has shrunk by 29% in the past year to 4.7 months.  Half of that decline is from builders creating fewer new homes.  The other half is from an increase in demand.  It wouldn’t take much more demand to push that figure into shortage territory.

I’m not saying that demand will increase (although I suspect it will).  I just want o point out that relying on days-sales figures for conclusions is potentially dangerous.

 

 

 

musings on 2012

Please take my survey, if you haven’t already.  It’s brief, anonymous, and will help me focus future posts.  Thanks.

PSI reader survey

2012?!?

Yes, you’re reading the year correctly–2012.

Why so soon?  Two reasons:

First, stock markets around the world seem to me to be laser-focused on the here-and-now.  As a general rule, any successful investor has to have a perverse streak–the fact that everyone is doing one thing is prima facie a reason to set out in a different direction.  Besides, focusing exclusively on today and tomorrow is playing the day traders’ game.  Great for passing the day, great for your broker–bad for your portfolio.  The edge, if there is any (the evidence is that day traders in the aggregate lose money), in this game is with the guy who has the most advanced trading software or the itchiest trigger finger or, in today’s world, is co-located with the marketmaker.

That’s not me.  I don’t think it should be you either.  We should be working smarter, not harder.

2.  Some people are beginning to argue that what we are now experiencing is not a simple correction in an ongoing bull market, but rather the first signs of a fundamental change in the direction of the market to the downside.

Their argument starts with two suppositions:

–turmoil in the Middle East will intensify, resulting in significantly higher oil prices.  This, in turn, will create a substantial headwind to world economic growth;

–the earthquake/tsunami/ nuclear power plant disaster in Japan will tip that country into recession (it wouldn’t take much, since Japan is barely growing). That, by itself, will have a negative effect on world growth.   In addition, supply chain disruption caused by damage to manufacturing plants in Japan will create added problems for industry internationally.

Together, the argument goes, these two forces are enough to cause a fragile world economy to slide back into recession.  Down world economy implies down world markets.

Could this be right?

my thoughts

it’s normally too soon to be worried…

Typically, the market begins to turn to earnings prospects for the following year in June or July of the current one.  Until summer, the market usually concentrates on the details of this year’s profit performance and doesn’t worry much about anything farther into the future.

…but these aren’t normal times…

2010, of course, was by no means normal.  Last year, investors refused to look any more than a month or two ahead until September or October.  Only when the positive evidence from corporate earnings reports became overwhelming did the market grudgingly begin to concede the possibility that 2011 might be an up year for company profits.

Once stocks began to move up, however, they didn’t stop until they had discounted everything positive that might happen in 2011.  Very unusual behavior, but the reason I had been expecting a correction.  It’s just too soon, for any market–but especially for one that has been so skittish, to begin to discount possible 2012 earnings gains.

The bears might cheerfully concede that that’s how the downturn began a month ago.  But, they would claim, the Middle East + Japan have turned a correction into something fundamentally different.

…so maybe a long glance ahead makes some sense

Another factor to consider:  we’ve just passed the second anniversary of the start of the bull market.  This is just an early warning indicator of the maturity of the advance. Some bull markets, like the one that began in 1992, have lasted far longer than two or three years.  But we can’t rule out the possibility of a market downturn in the easy way we could have in 2010.

So, contrary to the way things usually, maybe–just to be safe–it makes sense to take a guess at what 2012 might be like.

my yearend 2010 view

My base case for 2011 made at the end of last year:

–earnings of $100 for the S&P 500, which might be a little aggressive,

–a multiple of 14x, maybe 15x if we’re lucky,

= an index target of 1400-1500 for the S&P.

a rough guess for 1012?:

–eps growth of 10%-15%, as economies gradually return to normal and short-term interest rates begin to rise,

–a multiple of 13x-14x on those earnings,

= a target of 1430-1610 on the S&P.

If those guesses were anywhere near the mark, it would imply that 1012 would be an up year, but with the market rising less than 10%.

what’s changed since then?

How do Japan and the Middle East change these figures?  I don’t feel comfortable putting down precise numbers for either.  But I think it’s safe to say that the entire negative effect, both in Japan and elsewhere, of the earthquake will occur in 2011.  This means 2012 will benefit not only from the absence (we hope) of a comparable negative event, but also from the positive stimulus coming from reconstruction efforts around Sendai,.

Similarly, the negative effect of higher oil prices, provided they stay within a reasonable distance of the present level, will be felt throughout most of 2011.  Absent comparable increases again in 2012, the negative effects will fall out of year over year comparisons by next March.

Consumer pain will be felt most intensely in the US, where low energy taxes mean that the percentage increase in prices will be larger than elsewhere and where consumers use mind-boggling amounts of petroleum products.  But, on the other hand, the US consumer is showing surprising strength, and is in the best position today to withstand the negative effect of more expensive oil.

my conclusion

I find that these thoughts are pushing me toward a conclusion that’s different from what I’d expected. Japan may clip a percent or so off S&P 500 earnings growth this year, but will add a similar amount next.  Higher oil prices may shave another, say, 2%, from S&P earnings growth in 2011 but have little effect on the 2012 tally.

In other words, the Middle East and Japan will end up making the growth rate of 2012 earnings over 2011 results higher than it otherwise would have been.  An S&P level above 1400 may therefore prove hard to surpass in 2011, but one of 1550–a 10% gain–looks easier to achieve in 2012.  By slowing down and stretching out the pace of economic recovery, Japan and the Middle East may make it more probable that the rebound stretches well into 2012.