This weekend, Barron's published its annual market prediction survey (subscription required) open to its readers. #11 is always a tough one for me: Which Dow Jones Industrial Average member will perform the worst in the coming year? I said JP Morgan last year, and it wasn't even close. The biggest loser was American International Group (AIG), which was booted and is down 97%. Of the remaining DJIA members, General Motors (GM), not surprisingly, is down the most. At least I did better on my pick for the best one, Johnson & Johnson (JNJ), which should end the year in 3rd or 4th place.
I don't spend a lot of time or effort analyzing large companies, but it is important to have a feel for their prospects due to their large contribution to the broad markets in terms of market capitalization as well as economic impact. While 2008 was a year that saw the demise of one "general" (GM), which actually was my pick for the Barron's contest due to my expectation that the equity gets totally wiped out, 2009's most devastating loss could come from its other "general", General Electic (GE).
GE didn't exactly have a great year this year, as it is down almost 57% despite an infusion from Warren Buffet. It has actually been a while since GE had a good year, as it has declined in each of the three previous years as well, underperforming the S&P 500 quite substantially along the way, especially this year (its first double-digit negative relative performance, most of which has transpired in just this quarter). From a big picture perspective, GE, the traditional epitome of earnings stability, hinted at serious underlying challenges in the summer, when it missed. Analysts and investors, who for years have sought more disclosure regarding the massive GE Capital unit, began to question a little harder. GE then surprised the market by selling stock into a huge down bid, and it has suffered since then. While the stock has bounced, it hasn't made up much of the losses relative to Industrials in general, trading more like a Financial. Relative to the broad market, the stock sits near its lows, as you can see in the chart below.
You might look at the chart and conclude quickly that GE is extremely cheap. After all, the price hasn't been this low since 1997, it has underperformed the rest of the market rather substantially since the 2000 peak (and is back to 1995 relative levels), its PE bounced off of a 20-year low and its P/B is the lowest it has been in decades (and close to the magic 1X). No one has been showing this company any love!
In a bull market, when you try to play "mean-reversion", you can get stuck in a value trap. The stock is cheap for a reason and fails to participate in a rally. In a bear market, though, you can fall into a value pit. Every single failed financial was cheap and lauded as such before it was wiped out. Ask Bill Miller, Rich Pzena or practically any investor in Financials over the past year. I even confess to succumbing to the siren's call for the GSEs.
So, why do I think that GE might actually be more of a "pit" than a "trap"? Last week, I warned investors to steer clear of companies with "big bad balance sheets", briefly citing GE as an example. The balance sheet is horrible, and faith in the company is rapidly waning. As I will highlight below, they have a ton of debt, much of it short-term. They had attempted to sell some assets, but they suspended those efforts. Perhaps my thesis is too simple, that this massively leveraged company could struggle with liquidity, but take a look at the chart below to get a less rosy view of this great American icon:
While many may believe that "GE is worth less today than it was over a decade ago", it's simply not true. The equity value certainly has declined, but the enterprise value, which adds the net debt, has increased dramatically and isn't too far from its all-time peak in 2000. Make no mistake: GE has continued to party like it's 1999 until very recently, when it found its new religion (shrinking GE Capital). Now the debt-holders control a much larger piece of the pie than the equity-holders. As you can see above, this massive expansion of the balance sheet has hurt the return on capital while keeping return on equity at a high-double digit level. Here is what the balance sheet transformation looks like:
Note that these numbers precede both the equity sale as well as the preferred sale, so the liquidity is better than it appears. Still, though, the rapid expansion of GE Capital is quite evident, and it leaves the company with little flexibility in any downside scenario. Tangible equity is now dwarfed by its overall debt burden (share repurchases at high prices as well as acquistions). GE's industrial business, which is global in nature and extremely diversifed, should ordinarily weather isolated storms well, but this is no ordinary storm. Even without the potential credit problems from GE Capital, the core business should struggle. The weak balance sheet takes flexibility away from the company - no share repurchases, perhaps a slashed dividend (despite their maintaining otherwise), inability to potentially take advantage of other asset sales, etc.
It's no wonder that the company has been so aggressive in raising capital lately. The rating agencies, just slightly behind the eight-ball, have finally figured out that perhaps GE isn't really AAA quality. Weak fundamentals, pressure from the balance sheet, and challenging capital markets could make 2009 yet another year that GE shareholders will want to forget.
Disclosure: No position in GE