AB Analytical Services

When Free Cash Flow Isn't so Free

Today is the 4th of July, which ranks right up there with Thanksgiving at the top of my list of favorite holidays.  This is a day where we celebrate the freedom in our country that we still enjoy after declaring our independence 233 years ago.  Political freedom is a value that we typically associate with countries in which the entrepreneurial spirit thrives and the economy grows.  We shouldn't take our freedom for granted, as most people on our planet still don't enjoy the opportunities that we do.  It is exciting, however, to see individual rights improving for many in lesser developed countries, as we can expect these new-found freedoms to help them improve their standards of living in coming decades.  So, to all my fellow Americans, I wish you a Happy 4th, and to those who don't yet enjoy political and economic freedom, I offer my wishes for improvement in those areas.

Just as individuals who are free are more able to realize their potential, companies too flourish when they aren't so encumbered.  The world has changed greatly over the past year, and I continue to be extremely cautious regarding companies that are encumbered with too much debt and other liabilities.  Yes, a very strange segue and not exactly analogous, but stay with me!  We have moved to a world of deleveraging, where only the fittest will survive.  I have been harping on this subject as my number one theme for 2009 since late last year, though I have stayed off the soapbox for the past few months.  How soon investors forget, it seems, as many of the most unfit companies as measured by their earnings power and balance sheet strength relative to their debt burdens have been among the best performers.

Today, I want to discuss the notion of free cash flow.  There are a couple of ways to define it, which can lead to vastly different results.   A very popular method is to take the working capital changes that contribute to Cash From Operations (change in AR, change in Inventories, etc) and subtract Capital Expenditures.  In recessionary times, this method can mislead as AR and Inventory decline creating cash and CapEx gets cut to the bone as companies look to save cash.  It leads to a very positive view of a negative situation.  Another method is to take Net Income, add back depreciation (a non-cash expense) and then subtract CapEx.  In a receding economy like ours, often the depreciation gets slashed due to the write-off of Goodwill, creating a very negative change in the future FCF compared to the past FCF (income is falling and now depreciation gets cut).

Investors tend to value companies with "high" generation of FCF relative to the market cap.  If FCF is "real", it is a measure of what is truly available to equityholders for potential dividends.  There are many ways in which FCF isn't real - too many for me to discuss here and probably lots that go well beyond my accounting knowledge.  I already mentioned how declining companies generate increases in cashflow generation that are not sustainable unless the company totally shrinks away (which isn't usually a good thing!).  Another factor that can diminish the value of the calculation is when the company is a serial acquirer.  If the business model depends upon more and more acquisitions (using that "free" cash), what happens when the music stops (as it is in this environment)?  Similarly, often an investment in the business isn't classified as "Capital Equipment", but it is a necessary investment.  An example of this is the rental-car industry.  Finally, is FCF "real" when the company is spending all of it and then some on share repurchases? 

When it's all said and done, I think that there are a lot of "fake" FCF stories out there.  These tend to be companies that see their debt go up year after year despite all this "free" cash flow.  In this environment, where it is increasingly difficult and more expensive to borrow, paying down debt has become the highest priority for most of these companies.  For the next few years, many companies will have to cut dividends despite generating all this "free" cash flow.  I decided to run a screen of some companies with very high historical FCF generation relative to their current market caps but that are encumbered with debt and other liabilities.  In this environment, future FCF isn't likely to be as high as historical FCF, so anyone blindly buying these "high" yielding stocks (FCF/Market Cap) is potentially assuming solvency risk without adequate compensation.

In my screen, I took the S&P 500 and kept all companies trading at less than 12.5X P/FCF (i.e. an 8% or higher FCF yield).  Note that we are skipping some real potential pigs by omitting companies that don't even generate FCF.  Next, I constrained net debt to capital (total debt less cash) to 35%, which is slightly higher than the median of all companies in the index.  The next parameter is that I wanted to make sure that the Total Liabilities were at least 5X the trailing FCF, so I constrained FCF/TL to a maximum of 20%.  In order to strip out any companies that are growing so fast that they aren't likely to face potential liquidity or solvency issues, I constrained maximum EPS growth of 0% this year and 25% next year (though I am probably omitting some companies that still deserve to be on the list because they won't actually achieve the expected growth).  Finally, I limited my analysis to the Energy, Materials, Industrials, Consumer Discretionary and Consumer Staples sectors. 

These companies are down a bit more than the market year-to-date after being down as a group slighlty more than the market in 2008.  I also included a column that highlights the Total Liabilities relative to the Current Assets (the higher, the worse).  These stocks have a median forward PE of just 11, which perhaps looks good to naive investors that don't look past that single metric.  As a group, these companies have debt and other liabilities in excess of 10X historical FCF.  Most of these companies have very little or perhaps negative tangible equity.  Many of these companies may seem beaten up enough, but who knows.  Gannett (GCI), for instance, trades at just 2.5X expected earnings, but they have immense burdens and an imploding business.  In general, I don't expect good things for most of these companies.  I have written specifically about General Electric (GE) in the past and am very negative on that name again after calling off the dogs in March (see the comments from that article).  I called GE a "value" pit in that article, and I think that the description applies to most of these companies as well.

I decided to forge ahead and apply the same parameters to the S&P 400 Mid-Cap members.  For those unaware, this index is up sharply year-to-date.  The results from the screen kicked out several names with similar characteristics (not surprisingly).  The shocker was that this group is up a median of 17% after declining a bit more than the large-cap group in 2008.  So, some of this year's performance may be making up for last year's action.  In some ways, the big companies have bigger problems in absolute dollars, but some of the names on this list are likely to encounter unfriendly financiers as well.

I know that Oshkosh (OSK) just won a big contract, but is it enough to overcome their horrible balance sheet?  United Rentals (URI), a failed LBO, is a great example of fake free cashflow.  We found that out when they wiped out a lot of the Goodwill late in 2008.  This is a company that had $726mm in equity at the end of 1998 and $2.04 billion at the end of Q3-2008 only to end up with -$29mm at the end of 2008.  In a decade, it paid no dividends and saw its equity wiped out.  Its total debt grew by over $1.7 billion during that decade.  Ironically, its share count went up but came back right to where it started after they repurchased a bunch in 2008.  That was a brilliant move - 31% of the company at 22, spending $600mm.  Oh, over that decade they produced FCF of $5.5 billion.  Go figure.  The answer is that the calculation of FCF is flawed - the company has minimal "capital equipment expenditures" but massive investment in its rentable inventory (not called inventory though, as that is stuff for sale).  So, they spend big bucks every year on something that's not inventory and not capital equipment but used as the core of their business.  There are lots of companies out there like this (as an aside, this is my issue with Aaron's Rentals (AAN) about which I wrote recently).

Let's conclude with a quick look at Regis (RGS), which is a serial acquirer in a very slow-growth industry (hair salons) that is actually more economically sensitive than many recognize.  They last did an acquisition in early 2008, and their sales growth, which was steady for so many years, declined sharply (down 14% in Q4 and 11% in Q1) after the following annual growth rates: 

• 6/2008:   4% (store closings)
• 6/2007:   8%
• 6/2006:  11%
• 6/2005:  14%
• 6/2004:  14%
• 6/2003:  16%
• 6/2002:  11%
• 6/2001:  15%

Organic growth slipped from 4% to 3% to 2% over the past few fiscal years before falling to -1.4% in the first three quarters of FY09.  The company generated FCF of $538mm over the past 5 years ending in June 2008.  It paid dividends to shareholders of about $36mm.  The company repurchased stock in 2008 and 2007, spending a total of $135mm to repurchase about 4mm shares at about $34 per share.  The rest of the FCF went to pay for acquisitions.  Going forward, it's a slow-growth industry, these guys have a ton of debt and the game is over (acquisitions).  I wish them luck!

Tying it altogether, more than ever (after this big rally that has lifted some of these overleveraged companies) investors need to be very cautious about investing in any company.  The economy isn't likely to grow significantly until the next Presidential election in my opinion, and it could contract again.  Companies are slashing expenses and investments today to survive until tomorrow.  In that environment, overall sales are not likely to rebound.  If one feels compelled to invest in any stocks (rather than corporate bonds, which offer better downside protection by far), they ought to be investing in debt-free companies that aren't likely to endure losses.  The exercise I have shared today helps to avoid high FCF-yielding companies whose shareholders aren't likely to ever get their hands on that "free" cash flow.  I would turn the whole thing around and look at companies with no net debt, with FCF no less than 50% of total liabilities and FCF yields in excess of 4%.  There are 33 in the S&P 500 Large-Cap(in all 10 sectors, not just the ones in the screens above), 31 in the S&P 400 Mid-Cap and 69 in the S&P 600 Small-Cap (yes, I still prefer smaller vs. larger companies).

Disclosure:  No position in any of the stocks included in the discussion or the tables

2010 should be an "L" of a year

Thursday's payroll report led to some of the worst market angst we have seen since the big rally started, with the market plunging into its third consecutive weekly decline.  While the numbers didn't strike me as anything really that different from "more of the same", neither did the previous few that seemed to encourage some market participants.  I was pretty lucky to be a bear who was aware - aware that the market was quite overdone in March (and February too!).  For those who follow my views, I had expected an interim low in the market in the March/April time-frame, but at slightly higher levels that we ultimately reached.  Then again, the market stretched further to the upside than I expected when I  projected more a big rally in mid-March after having "Sponge-Bob" called the low in early March as one of the first to note the irony of the "666" low .  When looking at the markets, it's very important to remember that stocks are much more volatile than the economy:

See what I mean?  Over the past 62 years, stocks have increased a few points more than the nominal economy on an annualized basis, but the annual returns have been +/- 5-6X the median GDP growth at the extremes.  So, it doesn't seem that implausible that the stock market has round-tripped an almost 25% move as the market incorporated slowing sequential GDP decline.

We are half through the year following the worst stock markets in most of our lives.  I am sticking to my forecast that we end the year down.  My original forecast suggested that we would rally in Q2 (which we clearly did), but make a new low in Q3 before experiencing a strong Q4.  At this point, I am not that sure that the March low doesn't hold, but I do expect a move to at least 800 on the S&P 500 and wouldn't rule out significantly more damage.  Before reviewing where we are in the big picture as far as correcting the major economic imbalances as I have described for quite some time, I want to take a very long-term look at the employment situation.  I am not in the "V" but in the "L" camp.  I think that Obama's responses and the actions of the Fed could very well avert Great Depression II, but our best case is to see the economy growing by the next election in 2012.  Deleveraging has to happen, and it will take some time.

Unemployment is a symptom, not a cause.  We are "over-stored" and suffer from an abundance of goods (relative to true wealth rather than borrowing capacity).  Unfortunately, it is a symptom that feeds into a negative feedback loop.  The higher it gets, the worse the credit situation becomes.  In the chart below, you can see that this is clearly becoming the worst labor market in generations.  To answer the question in the bottom panel, we are a maturing economy.  The "good times" didn't lead to high employment growth, and the "bad times" are leading to off-the-charts reductions:

The worst part is that we continue to see the duration of unemployment extend:

It's going to get worse.  Employers are trying to retain workers by chopping wages and hours.  I will be surprised if the average wage doesn't decline year-over-year at some point in 2010.  Employers were reticent to fire in most of 2008 and certainly recognized the high inflation in prices their employees faced then.  Neither of these is the case at this point, as inflation is plunging and employers aren't shy about slashing payrolls.  As a generalist who follows many companies from varying sectors, it is clear to me that head-count reduction is the rule not the exception:

So, the tick up in unemployment and in negative payroll growth along with the cut in hours worked and the flattening in overall wages not surprisingly roiled the market.

The market is starting to focus on 2010, which is just 6 months away.  As usual, the analysts appear WAY too optimistic on earnings.  According to S&P, the S&P 500 company earnings based upon the aggregation of company consensus estimates are expected to rise a very strong 33% to $74.  This would leave them 10% shy of 2007 earnings but 50% above 2008 trough earnings.  Where can I buy some of that stuff?

As I have written before, we won't resume strong economic growth until we see:

• Housing prices stabilize
• The savings rate normalize
• Deleveraging for banks, corporations and state & local governments near completion

Housing prices have stopped accelerating in their decline, but they remain steeped in a downtrend.  I follow Case-Shiller for lack of any better metrics, and they continue to indicate that most large markets are down close to 20% year-over-year.  Until unit demand stabilizes, this won't happen.  It is worthwhile remembering that the affordability has probably never been greater - low interest rates, government incentives and lots of desperate sellers.  With so many years above the mean, I will be shocked if unit growth isn't slow for the next several years:

Folks aren't spending like they used to - funny how unemployment and contracting credit mix:

Spending is declining due to payroll slashing and the remaining workers trying to build savings.  To me, this looks like another couple of years of headwinds for the economy and tells me corporate bonds are probably the place to be relative to stocks.

The final area is deleveraging.  I don't have a pretty chart - sorry.  I think that we have only started this process.  I noted in May that the floodgates had just opened, and we have seen a ton of equity issuance since then.  All this stock for sale is quite the reversal from the massive repurchasing that was going on up until Q3-2008.  This action should help stave off Armageddon, but it will keep prices under a lid.  Look for higher interest rates and equity dilution to rob from EPS growth.

So, the bottom line is that the economy will limp along at best.  I can't yet offer a 2010 stock outlook because I don't know how the rest of the year will shape up.  I tend to discount my original forecast of a new low in the 3rd quarter, but I learned last year and earlier this year not to be surprised to the downside.  That's the risk in a deleveraging economy.  In any event, I don't expect the S&P 500 to break 1000 over the next 18 months.

Disclosure:  No stocks discussed

Q2 Stock Returns by Sector and Market Cap

What a quarter it was!  As I predicted near the beginning of the year, Q2 was the first positive one for equities since the summer of 2007.  I was obviously a bit surprised with the extent of the rally, as I had been looking for the S&P 500 to find a peak in the range of 860-920.  I expect that stocks will decline this quarter as we backfill.  My outlook hasn't really changed from the beginning of the year - still looking for "the" bottom in Q4, though it may very well be that the March lows ultimately hold.  I am not ready to share my outlook for 2010 (as it depends a lot on what happens in the next few months), but I expect a dull market at best as the economy remains pressured.  If we don't back up now, I predict it will most likely be a tough 2010.

In the chart below, I have arranged the returns of each of the economic sectors by market cap (Large-Cap, Mid-Cap, Small-Cap).  I have color-coded it so that green represents a 5% excess for the quarter relative to the underlying index and 7% for YTD.  Similarly, red represents a 5% short-fall relative to the index for the quarter and 7% for YTD:

Source:  Standard & Poors

The first thing that jumps out at me is the stark difference in the returns across market capitalizations for Energy, with S&P 500 declining 10% while S&P 600 increased 40%.  Anyone familiar with my contributions might recall my article from March 28th pointing out this opportunity.  I think that the trade has probably gone too far the other way at this point and am cautious on smaller Energy names.  The second thing that begs attention is that Technology extended its relative gains across capitalizations.  This performance is quite impressive given that the market conditions were essentially mirrors in the two quarters.  Technology is at or near the top in all capitalizations, especially so in Large-Cap.  The final general observation I care to share is that Large-Cap Staples and Health performed starkly differently than in Mid-Cap and Small-Cap.  I tend to think that this is a function of "big money" increasing its risk profile, essentially "buying beta". 

During the quarter, smaller names tended to do better than larger names generally. I have already mentioned Energy's behavior.  Interestingly, while it has lagged YTD for the S&P 500, it is one of the strongest sectors for other capitalizations.  I mentioned earlier this year that I favored the sector for its better-than-average balance sheets.  In Materials, Small-Cap surged but remains a laggard on the year.  I believe that this action reflects how cheap it got in Q1.  Industrials are the weakest area in the S&P 500 YTD despite some "catch-up" this quarter.  I continue to believe that this sector will underperform due to the stretched balance sheets of the larger companies with captive finance arms.  Consumer Discretionary was uniformly slightly stronger than the overall market.  In smaller capitalizations, it remains one of the leaders on the year thus far.  Staples are somewhat of a conundrum, with Large-Cap and Mid-Cap suffering during the quarter relative to the Small-Caps, which were able to keep pace with the index.  One advantage that the smaller names have is better growth profiles.  Also, they tend to have better relative balance sheets.  YTD, this has been a hot sector outside of the S&P 500.  Healthcare was in line outside the S&P 500, which was weighed down by a weak biotech tape.  I personally hope to see the S&P 600 return for this sector elevate relative to the market, as I have about 1/3 of my equity exposure in those types of names.  Financials were extremely strong for the S&P 500 but quite below average for the smaller capitalizations, reversing out the relative performance over the past year or so.  The sector continues to lag the overall market across all capitalizations (anyone else see the yellow flag waving?).  Additionally, it is pretty clear that smaller institutions are now struggling with deteriorating credit.  Tech - yowsa.  They win in a bear market, they win in a bull!  I mentioned early in the year that the sector has one of the strongest balance sheets generally, which helped in Q1.  Beta-grabbing helped in Q2.  My editorial comment is that this is a mean-reversion waiting to happen (I own none personally or in either of my model portfolios).  The final two sectors, which are pretty small, suffered for different reasons.  Telecomm Services is reflecting a competitive pricing environment and very leveraged balance sheets, while Utilities got hurt by the beta trade as well as the rise in long-term interest rates.

Disclosure:  No stocks mentioned

Volcano: Could the Stock Erupt Soon?

I have spent the past couple of months pursuing a theme that I think makes a lot of sense.  I believe that medical device companies that sell a high amount of consumables (relative to capital equipment) will continue to grow strongly despite some recent inventory destocking that may have hurt short-term sales performance.  If you check out my holdings, you will see that I own four names that attempt to capture this thesis:  C.R Bard (BCR), Somanetics (SMTS), Angiodynamics (ANGO) and Volcano (VOLC).  Today, I would like to briefly discuss the investment case for the one I consider the riskiest, VOLC.  I apologize for brevity, but I am recovering from shoulder surgery and am typing one-handed.

To back up, I identified a universe of about 80 companies that fall into the category of device manufacturers with highly recurring revenue.  As I tempted to slim this group down, gross margin was one of the key attributes that I thought might highlight barriers to entry.  The last thing I want in a down economy is a commodity manufacturer!

Volcano is a relatively new company, focused on cardiac care.  Its main product is a system known as intravascular ultrasound (IVUS) that is used to help with the placement of stents.  It competes in this area with primarily Boston Scientific (BSX), but this "David" is beating the "Goliath".  I like the CEO, Scott Huennekens, who owns 2% of the company and takes a long-term view in developing the business.  He has executed a couple of technology acquisitions as well as continues to invest heavily in R&D (16% of sales) as the company seeks to leverage its position in the catheter lab by integrating adjacent technologies and adding functionality.

Sales growth has been torrid, with 31% growth in 2008 and 34% in the March quarter.  Gross Margin has expanded over the past couple of years from 61% to 63%.  The company has a strong balance sheet, with almost $3 per share in cash and no debt.  The company isn't yet profitable, but it's close, with analysts projecting a profit in 2010.  I have noticed in the past when high growth companies become profitable, the investor base broadens.  In any event, I find the valuation quite compelling at just 3X sales.  My target for year-end is 4X projected 2009 sales, or $19 per share. 

 

I don't know if VOLC is an acquisition candidate itself, but I do believe that we will see some consolidation in Med-Tech.  Most recently, Covidien (COV) acquired VNUS.  In the case of VOLC, I would note that St. Jude (STJ) recently acquired a competitor in the functional measurement area (FM).  The high recurring revenue business model of VOLC makes it attractive to any company that sells equipment to cardiologists.  Given that VOLC works with everyone but BSX, though, I am not counting on this exit strategy.  For those interested in learning more about the company, I would point them to the recent cover story of In Vivo magazine.

Disclosure:  Long VOLC and long in Top 20 Model Portfolio

Paired Trade: Buy Shoe Carnival, Sell Collective Brands

This is the 6th in a series of articles that attempt to identify relative value discrepancies between two closely related securities. So far, the first five (but not the most recent one - ouch!) have been modestly successful in aggregate, though it's a little early to be drawing conclusions:

		BUY	SELL
		MPR	NLC
13-Mar		7.30	11.99
22-Jun		10.21	16.00
		39.9%	33.4%	3.2%
		JNJ	AGN
17-Apr		53.05	49.49
22-Jun		56.09	46.48
		5.7%	-6.1%	5.9%
		COLM	UA
1-May		30.36	24.00
22-Jun		32.17	22.05
		6.0%	-8.1%	7.0%
		BCR	ISRG
8-May		73.52	158.77
22-Jun		74.35	161.15
		1.1%	1.5%	-0.2%
		EZPW	AAN
5-Jun		13.09	32.85
22-Jun		10.88	30.99
		-16.9%	-5.7%	-5.6%

For reference:

3/14: Buy Met-Pro (MPR), Sell Nalco Holding (NLC)

4/18: Buy Johnson & Johnson (JNJ), Sell Allergan (AGN)

5/3: Buy Columbia Sportswear (COLM), Sell UnderArmour (UA)

5/10:  Buy C.R. Bard (BCR), Sell Intuitive Surgical (ISRG)

6/6: Buy EZCORP (EZPW), Sell Aaron's Rents (RNT)

Today's idea is driven primarily by the sell, Collective Brands (PSS), which I find to be very expensive relative to a host of competitors.  I have written about Shoe Carnival (SCVL) in the past on several occasions, including late 2007, August 2008 and as part of a review of the first year of my Top 20 Model Portfolio (of which it is still a member).  I follow the shoe and shoe-related companies fairly closely and could select any number of other companies against PSS.  As you can see in the table below, it has one of the worst balance sheets but a fairly high valuation:

While I highlighted TBL and DSW as well, I chose SCVL as the other side as it remains so inexpensive. In addition to a pristine balance sheet and high inside ownership, this retailer had a great report recently, reducing absolute inventory and per-store again. The company isn't too exciting - focused singularly on selling shoes to women, men and children in low-income markets in the Southeast. Here's the comparison:

Don't be fooled by the low PE - PSS has a lot of debt and EV/EBITDA is a more appropriate metric.  Historically, the vertically integrated PSS (which admittedly has more moving parts) hasn't really had better margins than SCVL, but note that the EV/Sales ratio is more than double that of SCVL.  PSS is scaling back, while SCVL, with its strong balance sheet, is taking advantage of great real estate conditions to grow selectively.  With the economic headwinds likely to be protracted, it makes little sense to pay up to own PSS when SCVL and so many other similar companies are as cheap if not cheaper with less financial risk.

Disclosure:  Long SCVL

Paired Trade: Sell Aaron's Rents and Buy EZCORP

This is the 5th in a series of articles that attempt to identify relative value discrepancies between two closely related securities. So far, the first four have been modestly successful in aggregate, though it's a little early to be drawing conclusions:

• 3/14: Buy Met-Pro (MPR), Sell Nalco Holding (NLC)
• 4/18: Buy Johnson & Johnson (JNJ), Sell Allergan (AGN)
• 5/3: Buy Columbia Sportswear (COLM), Sell UnderArmour (UA)
• 5/10:  Buy C.R. Bard (BCR), Sell Intuitive Surgical (ISRG)

In this trade, I am looking at two companies that deal with credit-impaired or low-income consumers generally.  In the case of Aaron's (AAN), which just changed its ticker from RNT, the company "leases" appliances, televisions, computers, etc. to anyone without doing a credit check.  Not surprisingly, its sales have been strong lately.  My thesis is that it's easy to sell to someone with bad credit, but harder to collect when the economy is struggling.  It's not a bad business in a strong economy, but it's very risky in a weak one.

EZCORP (EZPW), on the other hand, is a pawn shop and payday lender, though it is moving into other areas such as auto titles.  When it sells used merchandise, it is a final sale, unlike AAN, which may have to repossess if the "buyer" doesn't keep up his payments.  While the payday lending is at risk, the low valuation of EZPW tells me that investors are paying very little for that business.  According to management (twice publicly to me on their conference call), the exit costs are minimal should the business become uneconomic.  Here's the tape:

EZPW is much cheaper on a PE basis, and it has a very strong balance sheet. AAN has a high EBITDA margin, but its D&A is huge.  AAN has also been boosting its sales by buying in franchises.  I don't know management at AAN as well, but I can say that EZPW management is very strong.  I believe that EZPW will trade towards 18 this year as the strength of its pawn business supports earnings growth, while AAN is likely to pull back towards 24.

Disclosure:  Long EZPW

Sector Review: Energy Moves Toward the Lead

Everyone knows how well Tech is doing this year, but May was the month for Energy to make a run at leadership:

 

You may recall that I highlighted an opportunity in small-cap Energy stocks near the end of the 1st quarter, so the 54% QTD move is gratifying.  This is a sector that I had highlighted early in the year as likely to perform well due to the superior balance sheets among its constituents.  At this point, I am thinking that the larger names look a bit better.

Small-Cap Consumer Discretionary stocks were too cheap at the beginning of the year, but they are overdone to the upside now.

Financials have been strong in large-caps but not in small-cap.  Is this an opportunity?  Probably not, as the fundamental outlook for smaller banks is deteriorating with the commercial real estate market.  The relative difference is rather extreme, with S&P 500 stocks up 38% QTD but S&P 600 stocks down 10%.  Don't chase it!

Utilities may be a great contrarian play now.  With Treasury yields rising and concerns over regulation of carbon emissions, the sector has been under pressure.

Disclosure:  No stocks mentioned

Fully Invested but Defensively

I first posted on Seeking Alpha 27 months and 227 articles ago.  For those who have followed my submissions, you are aware that I combine top-down and bottom-up analysis and technicals to produce those 2 articles a week on average.  You may not be aware that for the past year I have been running a model portfolio that reflects the views that I share here.  While the past year has been tough, with the S&P 500 declining in value by approximately 1/3, I am celebrating my Top 20 Model Portfolio's first anniversary appreciating that it has declined only 8% despite being fully invested over the entire time-frame.

Two things have helped me to beat the market so soundly:  active trading and a willingness to take concentrated sector bets.  While I certainly expected lower turnover when I launched a year ago, only five names remain from the original twenty stock portfolio.  We have bought and sold a few of the names on multiple occasions.  The fact of the matter is that high market volatility, such as we have experienced, leads to many opportunities for those willing to take advantage. 

The portfolio today is much different than the one I went with on the launch a year ago.  At that time, I was optimistic that the bear market was nearing an end and positioned the portfolio aggressively.  While it never really lagged the market despite its poor positioning, including a big zero in Fannie Mae (FNM), it has really done well since I repositioned it during Q4 for a more defensive environment.  Here is what it looks like now:

Before I share further insight about the portfolio, it's worth considering what it looked like on inception.  Below is a list of the 15 names besides the original five that remain in the portfolio (Catalyst Health (CHSI), EZCORP (EZPW) Stratasys (SSYS) and Ladish (LDSH) and Shoe Carnival (SCVL) which we sold and then repurchased):

• Americredit (ACF)
• Allergan (AGN)
• Administaff (ASF)
• Astec Industries (ASTE)
• Carpenter Technologies (CRS)
• Federated Investors (FII)
• Fannie Mae (FNM)
• Lincare (LNCR)
• Lowes (LOW)
• Middleby (MIDD)
• Men's Wearhouse (MW)
• National Instruments (NATI)
• NetApp (NTAP)
• Surmodics (SRDX)
• Timberland (TBL)

Other names that were added later but have been subsequently removed include Advisory Board (ABCO), BedBathBeyond (BBBY), Biomed Realty (BMR), Cisco (CSCO), Cintas (CTAS), Intuitive Surgical (ISRG) and Thor Industries (THO).  So, there have been a total of 42 names over the past year.

Looking at the current portfolio, it is pretty clear that I like strong balance sheets.  The highest net debt-to-cap names are rather average, while overall the portfolio has typically companies with net cash.  Similarly, I have been focused on price-to-tangible book.  While some of the names are quite distant from that metric, 13 of the 20 are below 2.5X.

Reviewing the list by sector, the Energy holdings represent a much larger portion of the Top 20 than they do of the S&P 500.  Chevron (CVX) is the only large-cap name, while the other three are small-cap.  Contango (MCF) is a producer leveraged to natural gas.  Carbo Ceramics (CRR) is also leveraged to natural gas but land-based and is more of a technology play.  Lufkin (LUFK) is involved in both energy, where it competes with Weatherford (WFT) as well as power transmission for industrial applications.  In all cases, these are "value" stocks.  Despite the big run recently, I am sticking with these names for now.

We are underweight Industrials, but our two names Ladish (LDSH), which we have trimmed significantly, and Met-Pro (MPR), a recent addition, are both very tiny companies.  LDSH is in a duopoly with Precision Castparts (PCP) in the jet engine component market and trades at tangible book value.  MPR is a company involved in green applications - water filtration and pollution control. 

The portfolio was extremely heavy in small-cap retailers early in the year, but we have trimmed a lot of the exposure.  What remains is a collection of small and rather inexpensive companies.  Dorman Products (DORM) and America's Car-Mart (CRMT) are both plays on the slowdown in new car sales.  Shoe Carnival (SCVL), which had a great report this morning, trades way too cheaply.  They sell shoes to a lower-income demographic, and the decline in gasoline prices over the past year as well as pent-up demand should continue to help them to perform better than typical retailers.  Columbia (COLM) is just a plain old-fashioned value stock, with significant inside ownership.  So, we are still overweight the sector, but in a defensive manner in my opinion.

We launched with no Consumer Staples stocks but have picked up some gems over the past six months.  We started with Hormel (HRL) around Thanksgiving and remain pleased with this very inexpensive food manufacturer with one of the best balance sheets in the industry.  We added Walgreen's (WAG) next, but have trimmed it after the nice run.  Finally, we most recently added Sysco Foods (SYY).  It has lagged its restaurant customers signficantly though it should benefit from some of the same factors.  The dividend is high and sustainable, a rarity these days.

Healthcare is our largest exposure.  Volcano (VOLC) is a recent add and truly a growth name with a very high percentage of its sales in consumables.  It competes very well with its larger, less-focused rivals, and I really like the CEO and his vision.  C.R. Bard (BCR) is more of a value play that I appreciate because they don't sell any capital equipment.  Catalyst (CHSI) is a small PBM with greater transparency than its rivals.  While it did very well last year, it has been a disappointment in 2009.  The valuation is compelling, but I am watching the 19 support level.  We caught Zimmer (ZMH) at a great time and have trimmed a bit recently, though it remains very inexpensive.  Investors are just too pessimistic on the ortho players.  This one has the best balance sheet and valuation.  Finally, we like the diversity and consistency of Johnson & Johnson (JNJ), and the valuation is very attractive.

Our only exposure to Financials is through EZCORP (EZPW), which is primarily a pawn lender being weighed down by concerns over its payday lending (regulatory).  The company has a fantastic balance sheet and should continue to be counter-cyclical.  It is truly a defensive name in many respects.  Our only Technology name is Stratasys (SSYS), which has been too cheap to sell but not particularly defensive except for its high cash and relatively low valuation compared to its book value.  I think that Tech could disappoint over the next couple of quarters and remain underweight despite the sector having better balance sheets than others.

The model portfolio doesn't allow me to make short bets or to move to cash, so it's important to remember that these picks are relative to the market and not absolute.  I happen to own 17 stocks currently, 15 of which are currently in the model.  As always, I post my holdings on my website.  I look forward to the days ahead, whenever they return, when I can invest with a longer time-horizon and not have to churn the portfolio so much.  I wouldn't expect to beat the market in that environment by 25% a year again, but it sure would be a lot less work!

Disclosure:  Long BCR, CHSI, COLM, CRR, CVX, DORM, EZPW, HRL, JNJ, MCF, MPR, SCVL, SYY, VOLC and ZMH

Dorman won't be Dormant Much Longer

The vastly altered landscape in the automobile retail industry, including the collapse in available credit last fall, concerns over the viability of the manufacturers and now the implosion of the dealer networks for Chrysler and General Motors (GM), is creating several opportunities.  While it took a while for some of my ideas that I shared in the Fall regarding taking advantage of these massive changes to play out, several of them have:

		PX 10/17/08	PX 05/15/09	Change
Auto Parts	AAP	27.58	40.66	47.4%
	AZO	106.60	158.01	48.2%
	ORLY	22.47	36.17	61.0%
	PBY	4.12	6.15	49.3%
Salvage	CPRT	32.09	29.19	-9.0%
	LKQX	14.66	15.25	4.0%
Finance	ACF	8.67	10.24	18.1%
Pawn	CSH	36.09	20.03	-44.5%
	EZPW	13.52	11.68	-13.6%
	S&P 500	940.55	882.88	-6.1%

So, while the market has been down, the four ideas produced a monster of a return from the first idea, a mixed return from the second, an excellent return from the third and a dud from the final area.  At the time, I disclosed that I was long ACF and EZPW.  I failed to pull the trigger on the auto parts players.

I followed up in February with a suggestion to buy Dorman Products (DORM), when it was trading below 9.  Well, egg in my face, as it traded as low as 6.12 a couple of weeks later, but I am happy to report that it has participated in the rally, trading as high as 12.50 in April and settling in a bit lower subsequently.  

The company makes replacement auto parts that are cheaper than the OEM replacement parts, and I expect that the aging of our cars due to the economic crisis should help the company to actually grow through the recession.  In that original article, I concluded:

My own expectation is that the stock may trade as high as 16 later this year, though it will require a couple of things to happen.  First, the margin erosion must stop by mid-year.  Despite the higher inventory than the company should be holding, I am optimistic that the improved sell-through should help clear that overhang.  The company reports on 2/27, so we may learn more about the outlook for margins then and perhaps see signs of inventory improvement.  Second, someone will have to notice!  I think that the fact that the stock trades at tangible book value but should continue to offer a decent free cash flow yield (once it works through the inventory), that it has little debt, that its growth outlook isn't nearly as bad as for companies in general due to the secular theme of cars being on the road longer, and that its margins have plenty of room to expand as input prices have now corrected and the pressure is lifting off of its customer base could be the catalysts.  I base my 16 target on a couple of different assumptions:

• 1.5X projected 2009 ending book value
• 13.3X my projected 2010 EPS of 1.20 (sales growth, margin improvement)

I had noted as well that it had an impressive list of institutional rosters but that I was concerned about a build-up in inventory.

I am happy to report that the company dramatically reduced inventory without sacrificing margin in the most recent quarter.  Also, with 3/31 filings now complete, all 4 of their major holders maintained or even expanded their positions during Q1.  I had added it to my Top 20 Model Portfolio (and have owned it myself), but I increased the size of the position in the model after their recent report.

While the stock is higher than when I first suggested it, so is the market.  Further, it remains cheap, as my original year-end target was 16.  I think that 15 should be pretty easy, and 18 is possible.  The main reason, though, that I am more excited at an even higher price is that I expect the dealer network collapse to benefit the company in the long-term.  As dealerships close, customers will either have to drive further or go to an independent repair shop, where they can get serviced for less money and with Dorman Products parts.  Finally, the chart looks great:

The stock has outperformed the overall market over the past 16 months (and longer).  It has an excellent balance sheet and trades at just 1.1X book value (1.2X tangible book value), affording it downside protection (absent crazy markets like March!).  The PE is just 10X one-year forward expectations (single analyst), which is very cheap considering the strength of the balance sheet and the likelihood of actually growing.  It seems as if the stars are aligning in the firm's favor, including the better times for the three companies that comprise 1/2 its sales:  AAP, AZO and ORLY.  As I said last time, if you like this one, be very careful buying it as it is EXTREMELY thin.

Disclosure:  Long DORM

Are You Ready for Range Trading?

The market appears to have topped on an interim basis after a sharp reversal this week, slightly but briefly exceeding the top-end (920) of what I had expected.  The S&P 500 fell short of its 2009 high set in early January  What lies ahead?  Another free-fall?  A quick reversal and resumption of "the new bull market"?  No, after a year of free-fall with meek rallies that couldn't get us to a zero return on a three-month rolling basis until late April, we are now set for "normal" markets after our first real bear market rally.  As you can see in the chart below, if the current level of the S&P 500 (883) holds up over the next few weeks, the 3 month move will be pretty much off the charts.  Even if not, it will be exceptionally high:

So, we will have moved from the absolute worst 3 month performance to one of the best over the past 40 years in a course of 3 months.  What a rally indeed!

I began this year with a view that Q2 would be the first up quarter since Q3-2007.  With the quarter 1/2 over now, it seems likely to be the case (as long as we hold 798 roughly, though dividends gives us a very small cushion).  In that forecast, I also predicted that we would make new lows late in the year and hopefully end the bear market.  You can review the whole analysis, but here is an excerpt:

My base case for stocks is that they decline about 15-20% this year (S&P 500 of about 720-765).  This level should serve as a multiple of about 12X-13X S&P 500 earnings I expect now for 2010.  I expect an interim low in late March to mid-April, a positive Q2, a low in late Q3/early Q4 (call it 625-675) and maybe a positive Q4 overall.  I believe that the biggest story in stocks this year will be the large losses in some of the largest names, like GE, T, WMT, and the large banks.  Unlike Q4, where stock-pickers had very little chance, I expect that we will at least have a shot this year despite the negative overall tone.  20-30% of stocks in the Russell 3000 could actually rise this year despite the overall pressure on the broad market.

At this point, it is clear that my timing for that first bottom was slightly off (and a bit lower than I had initially anticipated) and that the ultimate low may have already been made.  I expect the rest of the year to track my original forecast to some degree in terms of where we end up ( lower than here), but I don't think that we necessarily make a new low.  We could end up "testing" the old one - God help us if we fail!  For now, though, I expect to see a range trade of 800-900 on the S&P 500.  Here is a chart of the last two years:

 

A pure chartist may be salivating over what looks like a potential "inverse head and shoulders" pattern if we were to drop to 750 or so, and that may turn out later to be the case rather than a deeper test towards the old lows.  For now though, I think we do some work in that 800-900 area as we battle for a positive Q2. What keeps us from rallying?

• Equity issuance (see my article last week)
• Continued dividend reductions
• Realization that we are plateauing, not accelerating

What keeps us from crashing back down?  I don't have a lot of bullet points here, but I do believe that the market has adjusted to the capital crunch better and understands that not every stock needs to be puked out.  I believe that the armageddon scenario that encouraged so many professional investors to raise cash to unprecedented levels is off the table, and they will continue to be buyers on dips.  Later in the fall, the lows will probably tie into a realization that 2010 isn't likely to offer much of a recovery.  I am sticking to my prediction that the bear market ends then (even if March proves to be the ultimate low).  The rest of the year should be a trader's market.

I want to conclude with with a very long-term perspective:  Stocks are highly correlated to GDP.  In the chart above, the bottom panel indicates real GDP, which is falling (not so rare).  What is rare is that nominal GDP (the actual GDP, not inflation-adjusted) is falling, which creates quite a problem.  We need GDP growth to fix our leverage issues that exist at the personal, corporate and government levels.  In the past 60 years, the S&P 500 (before dividends) has almost precisely tracked the nominal GDP, growing 7% vs. 6.9% on a compounded basis:

If you look closely at the bottom two panels, you will find, not surprisingly, stocks lead GDP.  The GDP decline over the past year of -0.5% doesn't seem extreme enough to justify a post-Depression worst annual decline of 47% in the S&P 500 until one realized that the number is going to be a lot worse.  In Q3-2008, we produced at a $14.4 trillion annual rate.  If one assumes that the current level just reported for Q1 holds over the next two quarters (not likely to be that good), we would have a post-WWII low of -2.5%.  The reality is that it is more likely to be closer to a nominal decline of 4%, truly off-the-charts.

I continue to recommend that investors stick to good balance sheets.  Companies with bad balance sheets will be cutting dividends, selling stock, enduring higher costs of maintaining their debt and spending too much time worrying about financials rather than trying to preserve or grow their businesses.  That has been what I have been saying for quite some time, so nothing new there but a sense of urgency now that the rally appears to have ended.  I would also suggest that this might be a good time to write covered-calls. 

Disclosure:  No stocks mentioned