Monday, December 01, 2008

Staying in the Game

My sincere apologies to readers I have disappointed in my absence over the last several months. As our business has grown, time has certainly been at a premium and unfortunately, we have neglected our responsibilities to this blog. We hope to mend our ways with more regular postings of commentary regarding markets, economies, analyst upgrades and downgrades, as well as independent analysis of interesting companies.

Some of you may be aware of our regular monthly commentary to Marketthoughts, Henry To's excellent subscription service. Henry, who is currently working on his MBA at the UCLA Anderson School is a CFA charterholder as well as an actuary. Henry's thought provoking analysis and commentary is insightful and ruminative. His productivity in his subscription service despite his full time efforts as an MBA student is a real inspration to me. I hope to aspire to his level of publishing productivity! In Ocotober, I first published this commentary in Marketthoughts. I think most of this remains quite applicable:

Baffled? Frustrated? Worn out? Most of us have to answer yes to these questions. After over thirty years of investment management, I still try to stand up to my own sinking feelings and act professionally and as unemotionally as possible. A value discipline forces you to take notice, to battle your emotions, and to recognize value with at least a small order. Courage is in exceptionally short supply especially among newer clients who have never seen this before. But even when I visit some of the brokers who sell our products, many of whom have years in this business equal to or greater than mine, there is terror in their eyes and no activity in their books. It is never easy to battle feelings of inadequacy and powerlessness which overcome you in bear markets.

It's been over a year since housing issues triggered problems in mortgage markets which triggered problems in credit markets which triggered problems in the shadow banking system which triggered a bust in the commodity cycle, etc, etc, etc. The sequence of events reads much like the "begat" verses which describe generations in the Old Testament.

We have been through some twenty years of credit most "topping" experiences, as we neared the peak, more and more credit was needed to produce less and less real economic growth. The credit experience of the last twenty years parallels most other addictions where greater amounts of the abused substance are needed to achieve the desired result. Not unlike substance abuse, too much will indeed kill you.

The widespread deflation of asset values, whether stock prices, housing prices, or commodity prices has exposed the excesses of borrowing and destroyed the creditworthiness of the debt that was secured by the price inflation of the underlying assets.

All business cycles are driven by some excess "thing" that needs to be corrected. Many bear markets of the past have been triggered by credit tightening...not this time. Others, such as the internet bubble burst were triggered by excessive valuation of a sector...not this time. Others, such as the 1974 bear were triggered by fears of earnings collapse in the face of a seemingly uncontrollable macro variable, at that time oil some degree, this had been an aggravating factor again.

Abrupt changes in the availability of credit lead to abrupt changes in liquidity and hence, asset prices. This turns into a self-fulfilling prophecy...fears that asset prices may fall, lead to falling if not cratering asset prices.

The downward spiral of the current crisis parallels the emerging markets crisis of 1997 and 1998 where Thailand, the Philippines, Indonesia, and Malaysia faced currency attacks that undermined investor confidence in foreign denominated debt. Asia lost access to foreign credit, currencies plummeted and creditors lost confidence that they would get their dough back, all rushing for the exits at the same time. The decisions of the credit markets ensured that the crisis deepened.

The global economic response this time is much more heartening with bank recapitalization, broadened limits on deposit insurance, guarantees of bank debt, coordinated interest rate cuts, and major increases in liquidity. I suspect that much more can be done in terms of encouraging increased lending into the rea leconomy from the newly recapitalized coffers of the "favored few" banks. In addition, in this deflationary time, interest cuts have only begun.

The somewhat haphazard and piecemeal initial response to the crisis, especially in Europe has done little to boost confidence. However, following the UK's massive bank recap plan, the world began to coordinate it activity.

I am encouraged by some signs of life in the commercial paper market and by recent moves in LIBOR (finally.) As well, perhaps whimsically, there is now a TED spread gadget to be monitored on your iGoogle homepage. In my view, more of a sign of the late innings of a crisis than the beginning. We have also survived the Lehman CDS episode with nary a whimper.

The very high probability of a long and deep recession has prompted considerable fear recently. Though quite clearly, cyclical stocks
have reacted quite negatively to this prospect, most analysts have yet to revise their estimates downward for next year. Of course, this is causing some trepidation that more disappointment will follow. Here's a look at S&P consensus estimates according to Bloomberg and Bank of America stats.

Of all estimates that are higher in 09 versus 09:

Consensus estimates for 406 (82%) in the S&P are higher for 09 over 08. The overall average increase is +19% with a median of +11%.
  • 45 of 500 (9%) are up +30-200% averaging +64%
  • 34 of 500 (7%) are up +20-29% averaging 23%
  • 156 of 500 (31%) are +10-19% averaging +13%
  • 120 of 500 (24%) are up +5-9% averaging +7%
  • 48 0f 500 (10%) are up +0-4% averaging +2%

In my view, most investors/ speculators/ traders in this market are completely oblivious to Wall Street estimates in this environment. People are trading from the gut rather than from consensus estimates. I believe Roy Neuberger ( of Neuberger and Berman fame) once spoke of analysts quite disparagingly, " In a bull market, who needs 'em, in a bear market, they'll kill ya.) I also believe that in  a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates.

Recently one street strategist described a complacency that given stocks are down 30%+ that earnings misses are reflected in the valuations. According to him,"Magnitude of surprises on the downside can still surprise the market despite significant downward moves in the stock price prior to earnings release." As an example, Alcoa which had already been down 54% YTD dropped another 12% on its recent negative earnings surprise, and then fell another 27% after the earnings date. similar fates awaited shareholders of EAT, RT, IR, MWV, PEP, DPZ, JNY, SVU, NVLS, EBAY and others.

I have attempted my own analysis of negative earnings surprises. According to Zacks data between September 1st and October 23rd, there have been 190 companies that reported a negative earnings surprise of 10% or more.I chose the first 50 names of their screen for further analysis. Companies selected were not necessarily part of an index and had market caps ranging from $30 million to $72 Billion.

The average earnings surprise was -129%, obviously a horrific miss! The reaction on the earnings miss was as high as -37% though it averaged about -7.2%, even in these hardened times, a significant reaction.

However, after the earnings miss, the performance from that date to October 23rd was hardly supportive of the strategist's conclusion. In 25 cases, the stock outperformed the broad Russell 3000 index. In the other 25 cases, the stock underperformed the Russell. Here is a spreadsheet link outlining the findings.

Wall Street frequently puts far greater emphasis on its ability to forecast earnings as a stock picking methodology than is warranted. Though I have enormous respect for the work that analysts do, having served as a research director for a sell side firm, there are tremendous lags in information flow that can result in very limited usefulness. As well, GAAP  allows tremendous scope for a management to make choices or assumptions that are not captured in a single point E.P.S. number. My advice, look for confirmatory evidence of conservatism and focus on cash flow rather than earnings.

Some final thoughts for this month. The market abounds in very cheap stocks. Free cash flow yields exceeding 10% are relatively easy to find. This particular metric is always a standard that I find produces the first inkling of a decent business value. Naturally, all screening depends on observation of historical data, and it is dangerous to simply extrapolate the past into the hereafter. Look to return on invested capital for evidence of superior profitabiity relative to its peers. Explore the basis of this competitive advantage.

When credit is difficult to obtain, companies with free cash flow generation can obviously survive. Low capital expenditure needs, low working capital needs keep both commercial bankers and investment bankers from knocking at the door, or at least management need not answer their futile calls. The ability to self-fund is golden in these times. Great businesses have histories of free cash flow generation for some years, not merely flash in the pan occurrences.

The adage of investigating before you invest is more important than ever. pronouncements by strategists using selective data points may sound impressive but check the reliability of the may not always be complete. Though the Buffetts of this world may find a price to swing the bat with fierce determination when that fat pitch arrives, most of us do not have the intelllectual capital or emotional wherewithall to do so with confidence. Nibble and graze...diversify rather than feast. You will be able to concnetrate your positions later as evidence mounts that you have chosen well. Cash may seem like the greatest refuge but when a market abounds with bargains, it represents the sirens' lure.

In an environment where daily returns resemble traditinal monthly or even annual returns, volatility creates tremendous fear. Show some greed when the world seems to be falling apart. If your portfolio contains questionable stocks, use this opportunity to buy high quality names that you can grow wealth with through time.

Ignore Cramer and other prophets of myopic fortune or doom. These are times to think big and have long horizons.

It is exceedingly tough out there and easy to be discouraged. Be careful but stay in the game!


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