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- Monthly Market Review - Where does the market go from here?
- The Most Unattractive S&P 500 Stocks: Avoid Companies Like… United Parcel Service (NYSE:UPS) and Tyson Foods (NYSE:TSN)
- Kraft Foods Inc (NYSE:KFT) acquisition analysis of Cadbury Plc (NYSE:CBY)
- Embedded Expectations in Markets Around the Globe
- If the health insurers don’t do it, who is going to do it? The Case for Humana Inc. (NYSE:HUM)
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If the health insurers don’t do it, who is going to do it? The Case for Humana Inc. (NYSE:HUM)
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Email Articleby Christopher Pavese, Broyhill Asset Management (Guest Contributor)
This simple question, posed by legendary value investor Bruce Berkowitz, puts the consensus concerns surrounding the managed care industry into perspective. The bottom line is that the health insurers are the only shot we have at managing this mess. As much as he might like to, Obama does not have another entity to do it. And our growing government does not have the expertise or efficiency to manage the process.
The bear case for these stocks is well known and well discounted even at today’s levels. Let’s take Humana (NYSE:HUM), for example – 60% of the analysts that cover the company rate it “hold” or worse. To help put this number in perspective, a whopping 1% of the S&P 500 is rated “sell” today. So suffice it to say that the “bad stuff” is in the price. And when the bar is set low enough, it is not difficult to surprise on the upside. Perhaps this is why earnings estimates for the company have been marching steadily higher in recent months. So let’s consider some of the potential “good stuff” that might shift sentiment in the period ahead:
• Roughly three quarters of Humana’s premium revenue is driven by government programs. It’s safe to say that as long as the printing press is still running, Uncle Sam will pay his bills.
• Humana has experienced spectacular growth from these programs driven by Medicare Part D and the trend towards private plans.
• Management effectively capitalized on this opportunity when it was presented. As such, shareholders have been well served by the company’s strategic focus.
• Those receiving insurance through employers has declined this decade, but Medicare enrollments are rising steadily and expected to accelerate as baby boomers enter retirement.
• Humana’s decades of experience in Medicare programs gives the company a competitive advantage in dealing with new government programs for boomers and the uninsured.
• Humana spends much more on SG&A than peers resulting in significantly lower operating margins, and offering plenty of potential to ‘cut the fat’ out of the business.
But rather than throwing darts at potential positive surprises, James Montier recommends turning the process on its head:
Analysts are called analysts, not forecasters, for a reason. All investors should devote themselves to understanding the nature of the business and its intrinsic worth, rather than wasting their time trying to guess the unknowable future . . . Rather than trying to forecast the future, why not take the current market price and back out what it implies for future growth.
This echoes Ben Graham’s words that you don’t need to know a person’s exact weight to know whether they are overweight or underweight . . . The idea of investing without pretending you know the future gives you a very different perspective, and once you reject forecasting for the waste of time that it is, you will free up your time to concentrate on the things that really matter. So, when trying to overcome this behavioral pitfall, remember what Keynes said, “I’d prefer to be approximately right rather than precisely wrong.”
This is an exercise we perform regularly at Broyhill. If nothing else, we think we know what we don’t know. Accordingly, we seldom make forecasts. Lucky for us, accurate forecasting is not a prerequisite for portfolio construction or superior risk adjusted returns. Working backwards from today’s price is more consistent and a much simpler exercise. In analyzing Humana, and most of the managed care space, margin assumptions clearly drive intrinsic value. So it is critical to understand what margin expectations are priced into the stock today. Using consensus forecasts for long term top line growth (recall this is a group that is generally bearish on the industry) we estimate that current prices imply long term EBITDA margins of 2.4% using AFG’s Value Expectations. This implied margin should be viewed in the context of the company’s five and ten year median margins of 4.5% and 3.0%, respectively.
In other words, Mr. Market is already pricing in a near 50% haircut in Humana’s recent EBITDA margins by Uncle Sam. That’s pretty aggressive, even for Obamacare, and leaves plenty of room for upside surprises. We use the matrix below to estimate the stock’s sensitivity to changes in consensus sales and margin assumptions. The bottom line is that investors would require an additional 100 basis point reduction in consensus margin assumptions to justify modestly lower valuations. More importantly, upside surprises offer the opportunity for extremely handsome profits. We can live with those odds.
Source: The Applied Finance Group
Bruce Berkowitz of Fairholme Capital Management tries to kill the company rather than looking for all the information that would support an investment:
We look at companies, count the cash, and try to kill the company . . . We spend a lot of time thinking about what could go wrong with a company — whether it’s a recession, stagflation, zooming interest rates or a dirty bomb going off. We try every which way to kill our best ideas. If we can’t kill it, maybe we’re onto something. If you go with companies that are prepared for difficult times, especially if they are linked to managers who are engineered for difficult times, then you almost want those times because they plant the seeds of greatness . . . Companies die . . . Here are the ways you implode: you don’t generate cash, you burn cash, you’re over – leveraged, you play Russian Roulette, you have idiots for management, you have a bad board, you ‘de-worsify,’ you buy your stock too high, you lie with GAAP accounting.
Apparently, he was not able to murder Humana. Fairholme owns over 9% of the float.
Christopher Pavese
Broyhill Asset Management
http://www.broyhillasset.com/
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Embedded Expectations in Markets Around the Globe
Print ArticleEmail ArticleMuch like earnings results, when a company delivers 20% revenue growth, how does one determine whether that is a good or bad? It really depends on what expectations are priced into the stock that allows an investor to determine whether or not the company has delivered. But understanding the expectations priced into a stock is not an easy task, that is, unless you use The Applied Finance Group’s (AFG) Value Expectations (VE) interface.
AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedoes such as Cisco, whose expectations were unrealistically high.
The same way we can understand the embedded expectations in stocks, industries , and sectors, AFG seeks to determine which markets globally have high and low expectations vs. what they can realistically deliver. In many circumstances, if the imbedded future expectations are low relative to what they have historically delivered, the index is regarded as undervalued.
The charts below are recent snapshots of the expectations of different markets around the globe vs. what each market has been able to deliver historically. As an example, if you look at the chart that shows the World Expectations, over the last 14 years the median company in our global database has delivered 8.17% sales growth while currently there is roughly 8.83% sales growth priced in. This suggests that the market expectations are in line with what the market has delivered historically.
However, if you look at the current revenue growth of the median company around the globe they are delivering roughly 6% sales growth, almost 300 bps below the embedded expectations. If revenue growth does not improve, the current global market is overvalued.
The World
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 7.03%
Understanding Embedded Expectations
How Attractive Are World Markets Today?
United States
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 8.23%
Asia Pacific
Japan
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were -1.51%
China
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 11.94%
Singapore
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 15.81%
Europe
United Kingdom
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 3.35%
Germany
NOTE ON PAST EXPECTATIONS: In November 2009 Expectations Priced in were 5.82%
What Is The Value Expectations Interface?
AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedoes such as Cisco, whose expectations were unrealistically high.
After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.
In addition, the VE interface has all the key theoretical components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).
By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.
Value Expectations Interface allows investors to:
• Understand the performance expectations embedded into today’s stock prices.
• Build out Different Pro forma Financial Scenarios
• Determine NPV target price based on the users assumptions.
• Quickly determine if a company is over/under valued
• Benchmark valuation attractiveness against peer groups
• Efficiently Identify investment opportunities or potential torpedo’s
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Monthly Market Review - Where does the market go from here?
Print ArticleEmail ArticleFebruary was a good month. The S&P500 companies reported good Q409 results, with 75% of the constituents beating earnings estimates, and 10% meeting. In addition, the overhang of the widely unpopular health care reform seemed cleared, with Republican candidate Scott Brown elected to the Senate, ending the Democratic Party’s 60-vote filibuster proof majority. Investors’ optimism rose, sending the S&P500 index up by 4%, largely reversing the loss in January. High beta stocks led the way, with the top quintile stocks outperforming the R1000 and R2000 indices by 2.21% and 4.14% in the past month. (Equal weighted return. Please refer to What’s Working portion of the letter.)This has certainly been a much more pleasant start to the New Year compared to 12 months ago. A year ago, we were on a roller coaster ride, witnessing the S&P500 losing 8.6% in January, the worst in history, losing 11% in February, the second-worst on record, followed by a loss of 4.66% on the first trading day of March, another worst in history. Back then, we were attacked by horrific economic news on one front after another: a disheartening GDP decrease of 6.2% in Q4 2008, skyrocketing unemployment, falling home sales and prices, rising credit card defaults, and continuing banking troubles. Amid debates on the merit of “capitalism”, investors were dumbfounded by government’s plans to “save” the economy: the $787 billion stimulus bill, the Homeowner Affordability and Stability Plan, and the President’s ambitious budgets suggesting historical deficits for the country. The Federal Reserve made its own contributions to the rescue efforts, injecting $1.75 trillion into the economy starting in March 2009, including purchasing $1.25 trillion of agency backed mortgage securities and $300 billion longer maturity treasuries.
A year later, the capital markets are in a much better shape and investors are searching for answers to long term fundamentals of the US economy. In the mean time, the outcomes of those rescue efforts are being hotly debated:
1. We have had two consecutive quarters of GDP growth in the 2nd half of 2009 in the US, 2.2% in Q3 and 5.9% in Q4, on an annualized basis. Q3 GDP growth was driven largely by government programs, with both Durable Goods (helped by Cash for Clunkers) and Residential Fixed Investments (helped by First Time Home Buyer Tax Credit) up double digits. Q4 GDP growth was mostly driven by businesses boosting spending on equipment, software, and restocking inventory, while consumer consumption was weaker than expected, registering a growth of just 2%, down from a 2.8% growth rate in Q3. It is widely believed the brisk pace of GDP growth in Q4 is unlikely to continue, unless personal consumption picks up substantially to provide support for consistent business spending.
2. Unemployment was 9.7% in February 2010, flat from January, but was much higher than 8.1% a year ago. The Federal Reserve members forecast the jobless rate would remain in a range of 9.5-9.7% in 2010, improve to 8.2%-8.5% in 2011, and fall to a 6.6%-7.5% range in 2012. Economists say it will take until the middle of the decade for the job market to return to normal, after losing 8.4 million jobs in the Great Recession.
3. Stimulus Bill: Based on the Administration’s sales pitch in January last year that US unemployment would exceed 8.5% without the bill, the stimulus bill has failed miserably. The $93 billion tax cut given out in 2009 in the form of tax rebate geared towards lower income people, didn’t do much about consumer spending. The $159 billion given out to local governments to plug holes in local schools, Medicaid payments, and unemployment-benefits budgets, have relieved some budget pressures at the local level and saved some jobs. Among the remaining 65% of the stimulus money, $190 billion will be tax cuts and $150 billion will be local aids, which we can rather safely expect to generate the same old results witnessed in 2009. Hope is now on the $180 billion for infrastructure spending, which will be stepped up and possibly provide some real boost to the economy in 2010. That said, the bulk of the money for projects such as rail and water will take years to be spent.
4. The $75 billion Home Affordable Modification Program (HAMP) has been widely recognized as a failure. Almost a million homeowners have been on trial mods, ie, short term payment plans. About 25% that received trial loan modifications through the plan are failing to keep up with their new reduced payments, and at least 196,000 borrowers have missed some or all of their required payments. Only one in ten has had their mortgage permanently modified, although HAMP is designed to help 3-4 million Americans. Mortgage servicers were permanently modifying around 100,000 loans a month before HAMP started, and HAMP’s highest monthly total was the 50,000 additional permanent modifications achieved in January 2010. In addition, instead of declining, the number of foreclosed homes increased to a record 2.8 million in 2009, a 21% rise over 2008 and 120% over 2007, according to RealtyTrac. Despite the obvious failure, it is reported that the administration may ban all foreclosures on home loans unless they have been screened and rejected by HAMP.
5. Budget: After generating a $1.4 trillion deficit or 9.9% of GDP in FY09, the US is well on its way to generate deficit of another $1.4 trillion or 10.6% of FY10’s GDP. The White House’s FY11 budget released in early February called for $3.834 trillion in total spending, with a projected deficit of $1.267 trillion or 8.3% of GDP. The Senate extended the nation's debt limit to $14.3 trillion to accommodate the projected gap for the current spending year, which ends September 30, but with another $1.3 trillion hole next year, the nation's debt could reach $15 trillion by October 1, 2011, or about 95% of GDP. The projected $1.3 trillion deficit in 2011, assumes $122 billion extra revenues on overseas earnings from multinational firms, and letting Bush Tax cut expire, which according to the White House will generate $1.2 trillion revenues in the next 10 years. It is important to know that, the FY2011 budget has pension, welfare, and health care outlays accounting for 21%, 12%, and 23% of total spending respectively. In 1950, those percentages were 2.2%, 3.6%, and 2.2% respectively. In 1975, those percentages were 21%, 10%, and 8% respectively. Keep in mind, social security was initially signed into law in 1935 with the first payment issued in 1940. Medicare and Medicaid were established in 1965. History has proved it over and over that entitlement programs don’t just grow in absolute sizes, but grow faster relative to GDP and become larger shares of the overall economy as time passes by. That is exactly why the final push democrats are currently giving to the $1 trillion healthcare bill is extremely disturbing. The last thing the country needs is more deficits and more debt. Deficits can only be tackled through spending cuts and increased tax revenues, driven by GDP growth and tax increases (which we oppose). It is believed median economic growth rates fall by 1% once debt exceeds 90% of GDP, which the US will “accomplish” next year. The $1 trillion healthcare reform program, if passed and implemented, will just make it even harder for the US to reduce debt, in an economic environment with likely slower growth.
6. The Fed’s Quantitative Easing: Becoming the main purchaser of the mortgage market securities, the Fed has successfully kept the average 30 year fixed mortgage rate around 5% in the past year. Together with the government’s first time home buyer tax credit program, low mortgage rates has been widely credited for stabilizing US housing prices, which will have risen 7 consecutive months by December. The Fed will end the agency backed mortgage securities purchase program by the end of March as planned but doesn’t currently anticipate selling any of the mortgage-backed securities in the near term. Questions and doubts abound regarding the Fed’s exit strategy, though the latest 30 year TIPs auction(the 1st auction since Oct 2001) implies a long-term inflation rate of 2.5%, providing some relief to the urgency of Fed’s draining its excess liquidity. Regardless, Fed took its first step of exit by hiking the Fed discount rate by 25 bps in mid February, increasing the difference between the discount rate and the federal-funds rate to 75 bps, although still lower than the 100 bps before the current crisis.
And of course, the world is now flat as we know it and what happens in other parts of the globe is exerting increasing influence on the US economy and capital markets. Late last year, we had a brief shock from Dubai World, the state-controlled company of Abu Dubai, which announced it was seeking to delay debt payments as it negotiates to extend maturities. The event was viewed by some as the start of the final leg of the financial crisis, which had travelled from household default, to bank default, and to sovereign default. Unfortunately, the leg has since increased in size, as the sovereign debt crisis in Portugal, Italy, Ireland, Greece, Spain (PIIGS), has rattled the global markets since last December and accelerated this year centering around Greece.
Last week, the Institute for Supply Management reported that its services index rose to 53 in February, up from 50.5 in January and above the average estimate of economists for 51. The ADP Employment report showed U.S. private employers shed 20,000 jobs in February, fewer than the 60,000 jobs cut in January. The US economy is improving, despite largely failed policies of the Administration. The “unintended” consequences of those policies, however, will still take time to show their impact. In the months ahead, we await to see: how will the housing market react to the end of the Fed agency mortgage security purchase program and the expiration of the home purchase tax rebate incentive? Will private businesses start to hire if the healthcare reform passes which puts stricter requirement on employers to provide health insurance? The 10% comparable store sales gains in February for Nordstrom helped to cheer the market last Thursday, but will wealthier consumers keep their current spending level when a higher tax rate hits their wallets 10 months from now? Answers to those questions will determine consumer confidence, which will in turn affect consumption, the ultimate driver of sustainable GDP growth. Outside the US, will Spain or Italy become the next center of sovereign crisis now that Greece will be bailed out by Germany and France after it agrees to additional spending cuts totaling $6.5 billion? With this much uncertainty, we believe investors should sit tight.
So where does the market go from here? Recently, the market has continued rewarding the speculative companies, lending credibility to the belief that a sustainable recovery is underway. While that may indeed be the case, there are many portents that say otherwise. First and foremost is the battle of wills taking place over the health care reform. While the public is clamoring for something, the majority of the polls indicate that the currently proposed legislation is not the change most desire. The outcome of this legislation in the coming weeks will be important, as it could very well dictate the momentum and tenor for Obama’s remaining term. Put very simply, we think a big driver for the market in the months ahead will be determined by the outcome of this last push for health care reform. Should it pass, we think tougher times are ahead for the market. Our logic is simple: if health care reform passes in its current form, taxes will increase on profits and capital gains beyond the expiration of the Bush tax cuts. Further, a win here by the Administration will likely embolden it to pursue its “Cap and Trade” bill which will create new energy taxes and further reduce corporate profits. Between the current health care reform and a new run at global warming legislation, corporate Economic Margins will be squeezed via lower cash flows and higher cost of capital. That double shock combined with what is currently a fairly priced to over-valued market will likely result in declining multiples and thus share prices. Among the hardest hit stocks under such a scenario will likely be the winning momentum plays of the past 6 months, and high growth stocks. Should this legislation not pass, we expect the economy to continue moving forward, albeit quietly with high single digit unemployment being the norm. In such an environment, the current high beta stock wave may very well continue until a new catalyst reminds investors about the importance of valuation and risk.
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Why Are Bank Savings Accounts So Sacred? Over-insured depositors are the banking system's moral hazard.
Print ArticleEmail Articleby John Tamny, Toreador Research and Trading (Guest Contributor)
A popular belief among the economic commentariat today is that the mere existence of the Federal Deposit Insurance Corp. represents "moral hazard." With bank deposits insured, the common thought is that bank executives feel more comfortable taking massive risks because their losses will be covered by the taxpayer.
Well if we ignore that banks themselves fund the government bureaucracy that is the FDIC, the hypothesis about deposit insurance and moral hazard is questionable. Indeed, by virtue of bank executives having much of their net worth tied up in the banks they run (bonuses are heavily weighted toward restricted stock in the bank, as opposed to cash), it's a bit of a reach to suggest that deposit insurance--which doesn't protect the share prices of banks from collapse--somehow fosters excessive gambling meant to imperil that same net worth.
But what critics often fail to ask is why savings accounts are so sacred, and why the government-chartered FDIC, as opposed to a private version, has to insure those accounts. The answer we commonly hear is that without federally mandated deposit insurance, individuals would hide money under mattresses and banks would have no savings to lend.
A fair assumption at first glance, but if it were true it would also be true that no one would invest in companies listed on the stock market for fear that shares bought could go to zero. As we know, individuals are willing to regularly purchase shares in companies without any kind of insurance.
Investors in the stock market, however, are often risk-averse. And those who are can buy "puts" on shares purchased as a form of portfolio insurance meant to protect their downside--all without someone from the Nanny State holding their hand.
The above in mind, if the FDIC were abolished, it's likely that a private version of it would quickly materialize. If not, it's a good bet that private insurance companies would quickly step in to insure deposits, all the while keeping a watchful eye on the activities of the banks holding those insured deposits.
But assuming what is unlikely--that no private version of the FDIC would materialize in the absence of the federal version--would that be so bad? We keep hearing that banks have grown too large or that they're "too big to fail"; if so, what could be better than a lack of deposit insurance as a private form of regulation that would necessarily halt the ability of banks to take in excessive amounts of money?
Indeed, if savers were faced with the possibility of losing their savings altogether, it's near certain that just as they diversify their stock holdings as a form of wealth protection, so would they diversify their bank deposits. There would be a great deal more banks smaller in stature, but thanks to limits set by market forces, none would grow too large. While the idea of "too big to fail" is fanciful, it seems the problem lies in deposit insurance that allows individual savers to be unconcerned with where they place their savings.
Looked at in this light, when we consider "moral hazard" as it applies to banks, at some point we the savers must acknowledge that the moral hazard is us. Because our savings are over-insured, we don't stop to consider the activities or the health of the institutions we bank with.
Of course those who prefer a federalized version of deposit insurance will point to the near collapse of insurer AIG back in 2008 as an indication of why the FDIC should remain viable. Implicit in this argument is the view that someone else--i.e., the taxpayer--should be on the hook to make depositors whole if a large number of banks run into the ground and the FDIC itself lacks the money to pay everyone back.
This once again speaks to moral hazard on the part of savers, as opposed to banks. We want ironclad assurance from the federal government that insures our savings because it excuses us from doing any kind of homework on the banks we use--plus we know someone other than us will be penalized if it turns out we chose the wrong bank.
If we want banks to act better, or in less risky ways, we need to revise how we ourselves interact with banks. The problem here is that as long as a federal form of deposit insurance exists, we'll have no individual incentive to change. In short, the over-insured depositors are the banking system's moral hazard.
About John Tamny: 
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.
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Japan’s Cheapest Stocks – Nikkei 225
Print ArticleEmail ArticleThe Applied Finance Group’s (AFG’s) Economic Margin framework helps professional investors, corporations, and consulting firms to better understand the true economic profitability a firm is earning. In addition to corporate performance, AFG’s ability to understand intrinsic value and the embedded expectations in a stock is consistent across different companies, sectors, sizes and countries around the globe. This research process has been used by some of the most well respected firms since 1995 allowing AFG to grow their institutional client base to over 220 institutional investment firms globally that manage over $500 billion in U.S. equities. Because of the need for a more robust valuation model globally, AFG recently released research and investment tools that cover over 30,000 companies in 30 countries and expect to expand coverage over the next few years. If you would like to learn more about AFG’s international research platform CLICK HERE.
In this exercise we filtered through the Nikkei 225 Index and identified those with the most attractive valuations.
Then, we screened these companies based on their earnings quality score, eliminating the highest accrual companies, as they have proven to encounter negative earnings surprises more frequently than companies with low accruals.
The 25 stocks listed below rank highly based on AFG’s measure of valuation attractiveness, are most likely to outperform relative to their sector peers, and seem least vulnerable to run into a negative earnings surprise based on their current level of accruals.
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Source: EconomicMargin.com
AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).
Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.
Management Quality – Assesses management’s ability to make wealth creating decisions.
Benefits of Joining the AFG’s Market Forecast Project:
• Understand Trends of Investor Sentiment and Incorporate MFP Forecasts to Better Position your Portfolio
• Enhance Client Communication
• Actionable Long/Short Investment Ideas to help you Outperform!!!
• Use the "Wisdom of crowds" to Gain Insight into Popular Themes and Events in the Market
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On Buffett’s Berkshire (NYSE:BRK.A) Primer
Print ArticleEmail Articleby, Grey Owl Capital Management (Guest Contributor)
This past Saturday, Warren Buffett released Berkshire Hathaway’s 2009 annual report and his annual letter to Berkshire shareholders.* The last Friday in February has become like Christmas Eve for value investors the world over. A night of tossing and turning is followed by a mad rush to the computer to download the latest version at 8am on Saturday morning. And then, maybe 30 minutes later, melancholy as we all realize that Mr. Buffett won’t write to us again for 365 days. As admirers of Mr. Buffett, frequent shareholders, and practitioners of the “value” approach to investing, you could count us among the sleep deprived on February 27th.
Given Berkshire’s recent (and massive) acquisition of Burlington Northern Santa Fe, Mr. Buffett chose to make this year’s letter a primer on the various Berkshire business lines, as well as his value-oriented approach to investing. Here are a few thoughts on areas we found particularly interesting:
• Berkshire’s stated book value was $84,487 / share (page 3). Investments totaled $59,034mm with a cost basis of $34,646. If one were to mark these investment to market and then subtract 20% for capital gains taxes (estimate of federal and state), Berkshire’s book value is just over $97,000 / share. As of the close on March 2, 2010, the stock traded at $121,740 or 1.26x “adjusted” book value.
• Mr. Buffett has always shunned excessive leverage and talked about its many risks. He often admits that during good times the company’s equity might underperform more leveraged entities. “Sleeping well at night” is the reason he usually provides for this strategy. True enough, but 2008 demonstrated that over a full cycle, low leverage entities such as Berkshire can outperform because they are able to provide liquidity precisely when no one else can and in doing so receive outsized compensation. As he writes on page 4 of the letter, “When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help.”
• The 17th century philosopher Frederic Bastiat spoke of “what is seen and what is not seen” in regards to the unintended consequences of laws on the economic sphere. Mr. Buffett recognizes similar risks in over handed management and thus promotes an organizational approach at Berkshire that is as laissez-faire as the political approach recommended by Bastiat. On page 5, Mr. Buffett states, “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”
• In the Insurance section beginning on page 6, Mr. Buffett states the two critical aspects of the insurance business: 1) fairly unique in business, insurance operates on a “collect-now, pay-later model” and thus requires “negative” working capital – called “float” and 2) because enough people have recognized how favorable these economics are, the insurance industry as a whole operates at an underwriting loss. Berkshire offers shareholders a unique proposition: the firm has demonstrated an ability to invest the “float” in a very profitable way AND because of the superior managers and compensation structure the Berkshire insurance companies operate under, the firm has consistently operated at an underwriting profit.
• In the Utilities section, which begins on page 8, Mr. Buffett provides insight into why Berkshire is now willing to own such capital-intensive business when in the past they avoided them. Two explanations are given: 1) today, Berkshire is so big that Mr. Buffett has no choice but to look at opportunities he would have passed on before and 2) given the regulated nature of utilities, Mr. Buffett seems to believe that he is trading some investment upside for greater certainty. This makes sense to us. Other investors and financial writers (including Whitney Tilson) have articulated a third possibility: because Berkshire pays a “negative” rate on its borrowings (i.e. “float”) investments that would be unprofitable for others can be profitable for them.
• The housing market makes its way into the letter on page 12 in the Finance and Financial Products section. Given the lowest-in-fifty-years 2009 housing start number, Mr. Buffett believes that “within a year or so residential housing problems should largely be behind us.” While he is correct in stating that 2009’s 554k starts is well below the 1.2mm annual housing formation number, we think his optimism might be a bit premature. The recession has probably lowered the annual housing formation number and published inventory numbers are too low when bank “real estate owned” is considered.
• Mr. Buffett then discusses the structural problems at Clayton Homes that are a result of the government’s housing finance policy. The government artificially lowers the interest rate for conventional mortgages. Therefore, when financing is considered, a traditional home can be cheaper than the manufactured houses sold by Clayton. Mr. Buffett doesn’t say this but this is another example of Bastiat’s “not seen.” It also reminds us that in the current climate, government interference must be a part of the investment calculus.
• Berkshire is unlikely to experience the damaging impact of “group think.” In describing Berkshire’s derivative contracts, Mr. Buffett (on pages 15 and 16) assures shareholders that these contracts neither expose Berkshire to extreme leverage nor to counterparty risk. “If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
• Mr. Buffett concludes the financial section with a well-deserved excoriation of financial company CEOs and directors. However, regarding his defense of investors against the “bail-out” claim, we offer one final quibble with Mr. Buffett. He states, “Collectively, they [shareholders of the largest financial institutions] have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.” If he is using the term “owners” very explicitly, then, with the exception of Bear Stearns shareholders, perhaps he is correct. However, he leaves out the fact that bond holders of these same insolvent institutions, who knowingly assumed the risk of capital loss, were in fact bailed out to the tune of hundreds of billions of dollars and made whole by taxpayers.
That wraps up the highlights as we see them. However, the whole letter is well worth reading and it is available here: http://www.berkshirehathaway.com/letters/2009ltr.pdf
Sincerely,
Grey Owl Capital Management
Grey Owl Capital Management, LLC
This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.
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For additional information about Grey Owl, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.
The performance information presented above is reflective of one account invested in our model and is not representative of all clients. While clients were invested in the same securities, this chart does not reflect a composite return. The returns presented are net of all adviser fees and include the reinvestment of dividends and income. Clients may also incur other transactions costs such as brokerage commissions, custodial costs, and other expenses. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period, and the investment performance. Grey Owl Capital Management registered as an investment adviser in May 2009. The performance results shown prior to May 2009 represents performance results of the account as managed by current Grey Owl investment adviser representatives during their employment with a prior firm. The data shown represents past performance and is no guarantee of future results. No current or prospective client should assume that future performance results will be profitable or equal the performance presented herein. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.
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25 Most Actively Traded S&P 500 Stocks (ex. Financials) – Including Pfizer (NYSE:PFE) and Apple Inc. (NASDAQ:AAPL)
Print ArticleEmail ArticleIn this exercise we have listed the 25 most actively traded stocks (volume) over the last year and ranked them based on The Applied Finance Group's (AFG's) key investment criteria including valuation attractiveness, management quality and expected changes in Economic Margins (what a company earns above its true cost of capital). These companies seem to always garner the most attention from within the investment community, so we decided to add our insights into which of these firms look attractive and worthy of the hype and which you may want to avoid.
AFG’s criteria used in its stock selection process have proven successful at identifying winners and losers in the market including its proprietary measure of corporate performance (Economic Margin), valuation, management quality and earnings quality among other criteria.
Of the 25 companies listed that are heavily traded, eight stocks appear to be potential buys given their expected improvement in Economic Margins, attractive valuations, and wealth creating management teams. The list includes five stocks in the technology sector and one each in the basic material, consumer services, and health sectors.
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Source: EconomicMargin.com
AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).
Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.
Management Quality – Assesses management’s ability to make wealth creating decisions.
Benefits of Joining the AFG’s Market Forecast Project:
• Understand Trends of Investor Sentiment and Incorporate MFP Forecasts to Better Position your Portfolio
• Enhance Client Communication
• Actionable Long/Short Investment Ideas to help you Outperform!!!
• Use the "Wisdom of crowds" to Gain Insight into Popular Themes and Events in the Market
Why Participate:
Those that participate will receive insights that will only be shared with survey participants and participants will be the first to receive the results. In addition, as a participant you will have access to special research reports and seminars developed by The Applied Finance Group covering stock research, general market and economic issues.
Participant Commitment:
Participants will complete a short monthly survey dealing with the stock and bond markets, as well as select economic issues. As a participant you will be the first to receive the survey results before it is distributed to the public.
Who is AFG:
The Applied Finance Group is an independent equity research firm dedicated to helping our clients make better investment decisions. We help our clients take advantage of mispricings in the market, understand the market expectations embedded in stock prices and provide a set of tools designed to save investors time with their daily due diligence activities. For more information on The Applied Finance Group visit www.EconomicMargin.com.
How To Participate:
Follow the link below and fill out AFG’s Market Forecast Project Survey Application. Click here for more information and to participate. You will receive the results of our last survey and will be on our list to participate in next month’s questions.
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Texas Instruments Inc. (NYSE:TXN) - An Undervalued Stock
Print ArticleEmail ArticleThe Applied Finance Group’s (AFG’s) valuation techniques help investors identify and take advantage of mispriced securities in the market. One way investors can identify over or undervalued stocks is by using AFG’s Intrinsic Value Chart, which displays a company’s intrinsic value relative to its trading range and helps identify entry/exit points.
This easy-to-read chart identifies how far a stock’s trading range deviates from its intrinsic value (target price assuming immediate decay), which helps you recognize potentially mispriced stocks and pursue long and short opportunities. AFG’s Intrinsic Value Chart also contains a company’s Value Score (ranked valuation attractiveness), Economic Margin Change (expected improvement of economic profitability), and Accuracy (how well AFG’s default valuation has tracked the company). AFG’s valuation framework estimates a company’s equity value by subtracting debt and other liabilities from the total enterprise value. The total enterprise value is estimated by discounting projected future cash flows, utilizing analyst consensus, Economic Margin methodology, and the Decay concept which addresses the perpetuity bias in the traditional DCF model.
The example we have provided is Texas Instruments Inc. (NYSE:TXN) a company that currently looks undervalued according to AFG’s default valuation model. An important fact to note is that AFG has shown it tracks Texas Instruments Inc. (NYSE:TXN) well (high accuracy score of 100). Also, Texas Instruments has a current AFG Value Score of 82, meaning the company ranks in the top 82nd percentile of companies in the AFG universe in valuation attractiveness. Companies AFG identifies as undervalued have proven through back-tests to be more likely to outperform than those companies with an unattractive default AFG valuation rank.
AFG’s Intrinsic Value Chart:
• Identifies entry/exit points
• Shows how well AFG has tracked the company (accuracy)
• Displays the trading range of the company each year through time (blue bars)
• Displays the end of year closing price (dash on blue bar)
• Displays AFG’s default intrinsic value (red dotted line)
How to Read this chart:
• The Blue Bars represent the high and low trading range for a stock for each calendar year.
• The red dotted line represents Applied Finance Group’s (AFG’s) historical Intrinsic Value through time.
• When the red line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.
• When the red line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued.
AFG’s valuation techniques are one of the ways that AFG helps investors make more informed stock selection decisions. If you are a professional investor and would like to see if you qualify for a free trial of AFG’s research and suite of investment tools click here and an AFG Representative will contact you.
If you are not a professional investor Sign Up for ValueExpectations.com here to learn more about our stock selection process and potentially attractive investment opportunities.
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Professional Investors Like The Health Care Sector – Including Gilead Sciences (NASDAQ:GILD) and Johnson & Johnson (NYSE:JNJ)
Print ArticleEmail ArticleThe Applied Finance Group (AFG), an independent equity research firm, would like to invite professional investors/money managers to participate in AFG’s Market Forecast Project (MFP). The MFP is a professional investor sentiment survey designed to help money managers make more informed investment decisions, enhance client communication and provide an edge in the portfolio construction process. The main focus of the MFP is to provide participants investment ideas, macro-economic sentiment and stock market predictions of a large and diverse group of investment professionals to see how other professional money managers in the industry view the market.
This survey has been a huge success with our clients and we are now sharing the results with investment firms and professionals that wish to participate. There are no obligations to join this elite survey and those that participate receive the results first.
We look forward to you joining us in the Market Forecast Project! The larger and more diverse the group of participants, the more useful the results will be for all who participate. Below you will find information about how to sign up and participate in our upcoming surveys as well as find some examples of results from some of our previous surveys. If you should have any questions, please don’t hesitate to send me an email @ mghioldi@afgltd.com.
Sample results from last month’s survey:
• 35% believe that the Health sector is the most attractive sector to invest in
• 67% believe that U.S. home prices have yet to bottom out
• 39% believe unemployment will be 10-11% at the end of 2010
• 70% consider the Obama Administration to be “anti-business”
• 71% believe congress will pass more fiscal stimulus in 2010
• 76% find Large-Caps more attractive than Small-Cap stocks
• 39% believe the Brown victory in MA is huge and will change the tone in D.C.
• 45% believe the Brown victory in MA is significant today but will have no lasting effect if the economy improves
If you are a professional investor/money manager and would like to be a part of The Market Forecast Project... Click Here to join! Its fast and free to join!
Every month MFP participants are asked to share their favorite long and short investment ideas that all participants are able to access. Since the health sector is the most attractive sector to invest in we have provided the long and short ideas from the sector provided by survey participants as well as our thoughts on the investment attractiveness of their stock ideas using AFG’s Economic Margin methodology and valuation techniques. Two of the companies that made the list of best investments according to participants and AFG investment criteria include Gilead Sciences (NASDAQ:GILD) and Johnson & Johnson (NYSE:JNJ).
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Benefits of Joining the AFG’s Market Forecast Project:
• Understand Trends of Investor Sentiment and Incorporate MFP Forecasts to Better Position your Portfolio
• Enhance Client Communication
• Actionable Long/Short Investment Ideas to help you Outperform!!!
• Use the "Wisdom of crowds" to Gain Insight into Popular Themes and Events in the Market
Click here to participate!
Why Participate:
Those that participate will receive insights that will only be shared with survey participants and participants will be the first to receive the results. In addition, as a participant you will have access to special research reports and seminars developed by The Applied Finance Group covering stock research, general market and economic issues.
Participant Commitment:
Participants will complete a short monthly survey dealing with the stock and bond markets, as well as select economic issues. As a participant you will be the first to receive the survey results before it is distributed to the public.
Who is AFG:
The Applied Finance Group is an independent equity research firm dedicated to helping our clients make better investment decisions. We help our clients take advantage of mispricings in the market, understand the market expectations embedded in stock prices and provide a set of tools designed to save investors time with their daily due diligence activities. For more information on The Applied Finance Group visit www.EconomicMargin.com.
How To Participate:
Follow the link below and fill out AFG’s Market Forecast Project Survey Application. Click here for more information and to participate. You will receive the results of our last survey and will be on our list to participate in next month’s questions.
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Cheapest Stocks In The Hang Seng Index - Including PetroChina Co. LTD. (CN:857)
Print ArticleEmail ArticleOne of the key benefits of using The Applied Finance Group's (AFG’s) Economic Margin Framework is that it provides a systematic approach to converting as-reported accounting data into a performance metric that is comparable across time, peers, industries and even countries while eliminating many of the accounting distortions inherent in GAAP. The ability to understand the true economic profitability and the underlying intrinsic value of a company using one consistent method is why AFG expanded its framework internationally. Now investors all over the globe can take advantage of the same institutional quality research and investment tools that AFG’s U.S. clients have been using since 1996 to better understand the expectations embedded in security prices and take advantage of mispriced securities in the market.
AFG uses proven proprietary criteria to identify firms that are more likely to outperform their benchmarks, and filter out those that are least attractive. These criteria include variables such as management quality score, earnings quality, firm valuation and economic performance metrics.
In this exercise we filtered through the Hang Seng Index, the main indicator of the overall market performance in Hong Kong. The index contains 45 companies, which represents about 67% of capitalization of the Hong Kong Stock Exchange. Of these 45 companies we identified those with the most attractive valuations.
Then, we screened these companies based on their earnings quality score, eliminating the highest accrual companies, as they have proven to encounter negative earnings surprises more frequently than companies with low accruals.
The 8 stocks listed below rank highly based on AFG’s measure of valuation attractiveness, are most likely to outperform relative to their sector peers, and seem least vulnerable to run into a negative earnings surprise based on their current level of accruals.
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