The financial turmoil of 2007-08-09? has deeply affected households as well as businesses in most parts of the world. The reduction in the target Fed Funds rate since September of 2007 has been dramatic going from 5.25% (it really was this high!) at the beginning of this period to its current range of 0 to 0.25%. As any borrower knows, reductions in Fed Funds do not result in immediate parallel movements in interest rates that you and I pay, nevertheless, interest rates are likely lower than they otherwise would have been.
After peaking at a multi-decade high of +9.8% in July, the US producer price index (PPI), inflation rate has completely collapsed to +0.4% in November.
Little wonder that investors are huddling for warmth, are seeking "guarantees," and are about as risk-averse as I have ever witnessed. I warn my analysts about turning into "life insurance company treasurers" seeking relative shelter rather than seeking capital appreciation. Strangely, for long term real returns what appears to be safest in the capital markets at the moment may well be the most dangerous investment you can make,treasury bonds.
In this weekend's Barron's (subscription required) Rob Arnott, the former editor of the Financial Analyst's Journal provides some very thoughtful discussion in this interview by Lawrence Strauss.
As he describes,
"What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally, in November, we saw the beginnings of a rationalization where some markets did begin to recover-but some markets had been hit beyond any rational valuation of the risks associated with those assets."
Arnott goes on to describe very aptly, the behavioral tendency of most investors to continue to bank on "winners" rather than looking for bargains.
So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors.
He describes the current environment as "the richest environment of low-hanging fruit I've seen in my career."
A further key point...
"This is not a time to be hunkering down in the safety and comfort of the Treasury curve." "There are tremendous opportunities right now."This being the holiday season, I suspect that Mr. Market has provided us some gifts for the taking if we choose to partake. I will be putting together a number of screens of bargain or quality ideas that I think may contribute to a happy new year. As well, I will be providing a review of many of these names in the coming days and weeks.
I will start with a list of Stocking Stuffers, as you will see, not necessarily very high quality businesses with strong competitive advantages. This list was constructed using Reuters and the following assumptions:
- Price under $10 per share...i.e. Stocking Stuffers
- Operating margins on a Trailing Twelve Month (TTM) basis better than that of the respective industry and showing improvement versus last year or two years ago.
- Company must be generating free cash flow in the most recent TTM period
- PE multiple must be within 20% of the lowest PE in the last five years
- Enterprise Value/EBITDA must be less than six times.
Stocking Stuffers-Operating Margins, PE's, FCF
Stocking Stuffers-ROI, ROE
Stocking Stuffers- Debt Leverage
Here is another screen but rather than considering operating margin improvement, this screen looks for the following attributes:
- Price under $10 per share but above $1.
- Stock price below book value per share
- Cash exceeds debt
- Interest coverage more than two times
- Net earnings must be positive for the most recent twelve months.
Remember that frequently, book value can be a misleading metric for value investors. Companies which chronically earn below average returns on capital or equity may well have assets whose valuation needs to be written-down. Impairment of these overvalued assets can lead to too low a price to book ratio. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down Book Value and hence increase P/BV. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.
Book Value Bargains?
The Barrons interview makes it clear that Arnott favors investment grade corporate bonds at this stage. Spreads against treasuries have widened to immense gaps, for investment grade about 6% over treasuries, for below investment grade, perhaps 15-20%. As Arnott suggests, even if defaults reach historic proportions, it would take several years of defaults to lose a 20% spread in the competition against treasuries.
As Arnott concludes, and I agree, the less you hold in Treasuries, the better you are likely to perform in 2009. Riskier assets are priced to provide some significant returns for the coming years.
We'll have a deeper look at a few of the names within these screens over the coming days and weeks.