As I mentioned in a recent article, the changing environment will most likely demand changing valuation metrics. As companies likely begin to generate losses or at least substantially lower earnings as the economy deteriorates in a manner unprecedented in most of our lives, the popular PE ratio will likely prove to be rather useless. Many commentators, including myself, have noted how many stocks now trade at "book value" or less, but this valuation exercise is too simplistic: It ignores high levels of intangibles and goodwill, overvalued inventory, difficult to collect receivables and hard to liquidate plant, property and equipment in a deflationary environment. While I believe that there will be a greater focus on price to tangible book value, that metric alone won't suffice. Investors will have to incorporate true leverage of the enterprise as well.
What do I mean by "true leverage"? In very simple terms, the balance sheet consists of two main components: Assets and Liabilites. In a deflationary environment, different types of assets have more significance than others. I don't even pretend to have an easy way to grade in absolute terms the different components, but we know that in tough times cash is good and goodwill isn't. As I mentioned above, goodwill is worthless, while inventory, receivables and fixed-assets are worth less. Even cash, though, can be challenging. Is it invested in auction-rate securities (ARS)? Worse, is it stuck offshore? I think that many of these distinctions will be analyzed to a greater degree when trying to differentiate between companies.
On the liablity side, though, I believe that all of us investors will need to gain a better understanding of those obligations. While short-term and long-term debt are easily recognized and included in fundamental and quantitative analysis, what about other types of liabilities? My thesis is that investors will have to focus more on Total Liabilites, which includes a lot more than debt. Often a company can appear to be "debt-free", yet it has collected unbooked sales, which are a liability. Deferred Revenue, which offsets cash on the left side of the balance sheet, must be reduced over time by sales. In other words, the balance sheet's assets have been strengthened by tomorrow's delivery of goods and services. I am not an accounting expert and didn't even take a class in college (though I sure have spent a lot of time reading and learning from the CFA program and beyond), but it is clear to me that there are many, many types of liabilities that go beyond debt. Just take a look at the General Motors (GM) balance sheet to see what I mean.
I plan to spend a great deal of time trying to find "overleveraged" non-financial companies, as I expect that many of them will experience an even more significant downturn in 2009 than they did in 2008. My thesis is that companies with large financial obligations (total liabilities) will struggle to meet them as the economy declines. In the past, it hasn't been a problem, as many of these companies just "rolled over" their obligations as they became due. No longer is it this simple, as capital is being constrained. Companies can use cashflow, but it will likely diminish as the economy retreats. Selling assets could help, but that method could also face challenges as the likely buyers could be inundated by the sellers. A final method is to sell stock, and this is one that may become increasingly prevalent despite depressed prices. In this type of environment, it is the equity holder who will lose.
In future articles, I hope to highlight specific companies that should be avoided, but I believe that the reader can probably identify some obvious candidates rather quickly, like General Electric (GE). The recent ratings agencies warning about their AAA credit should come as no surprise (neither the action nor the fact that it is so late). With over $700 billion in total liabilities ($219 billion of which is short-term debt) and almost no tangible equity, one would expect to see asset sales (they suspended their attempt). One that seems not-so-obvious is ATT (T). Similar to many of its peers who compete in a brutal industry that could see intense pricing pressure, they have quite the bloated balance sheet. With a PE of 10 and a P/B ratio of 1.5, it sure looks cheap, right? The equity is valued at $165 billion, which towers over its tangible book value (-$22 billion). The company has $172 billion in total liabilities, including over $15.8 billion that must be rolled over this year (as of 9/30), net of cash. Its current ratio (short assets to short liabilities) is about 50%. The stock is down less than the market this year but has one of the largest debt-rollovers outside of the Financial sector.
As I said, this article focuses less on names and more on the big picture. According to my data source, StockVal, the S&P 500 companies have a cumulative market capitalization of over $8 trillion. The group of companies has total liabilities of approximately $22 trillion. In other words, what these companies owe is a lot more than the value their current owners enjoy. The various economic sectors, though, have vastly different profiles, with the bulk of the leverage confined to the Financial sector. Stripping that sector out, stocks currently worth about $7 trillion have total liabilities of $6 trillion.
In and of itself, I am not sure that there is any problem with having high financial obligations relative to the "worth" of a company, but, as we can see below, different sectors have vastly different ratios. Further, within different sectors, some companies appear to have fed at the trough a bit too long. Servicing costs for debt have been relatively low over the past many years due to cheap money. With access to capital shrinking and the cost rising except to those who either don't need to borrow or are the U.S. Treasury, the amount of debt and other financial obligations could become a burden. I believe that investors will be rewarded for avoiding those companies that could run into trouble. For starters, though, what are some of the key metrics for the various sectors of the S&P 500?
I have attempted to put the total financial obligations of the various economic sectors into context. The first two ratios compare total liabilities and short-term debt to market value. In an economy that could cause an inability to realize asset values via earnings or liquidation, equity sales could become more necessary. If it's not there, watch out! The next two ratios compare total liabilities to trailing EBITDA (which should come under pressure) and to current assets. These ratios help us get a sense on who might actually have to sell stock. The next ratio, tangible equity (which excludes goodwill) to total assets, gives us a sense of who has cash or hard assets that can be used to fulfill obligations. Finally, I included traditional valuation ratios that I expect to become increasingly less helpful.
As I review the table, it is clear that the Financial sector is still very leveraged, though this isn't too surprising. Many proponents of the Tech sector have correctly pointed to the strong balance sheets, and it certainly is apparent in the graphic. While Healthcare companies typically carry more goodwill, the overall metrics look favorable. In a surprise to me, Energy looks quite healthy on a relative basis, though the balance sheets tend to be weighted less towards current assets than long-term ones (and those reserves aren't gaining value). Materials aren't as solid as Energy companies, but the sector appears to have better than typical characteristics generally. Industrials look ripe for further investigation, as clearly several companies are stinking up the joint (beyond GE). Similarly, Consumer Discretionary looks to contain several potential landmines. Two sectors that look unfavorable but probably aren't as bad as they seem are Consumer Staples and Utilities. The cashflows tend to be more stable and thus the reliance upon balance sheet metrics should be limited (hopefully). Finally, an area that is downright frightening to me is the Telecommunication Services - it's not just T. My discussions with clients and peers leads me to believe that the market is potentially turning away from absolutely horrible balance sheet metrics due to a perception of stable cashflows and easy access to the capital markets. In any event, there is variation among the components of each of these sectors, though some of the sectors in general stand out positively or negatively.
The Bear Market's first leg down hurt mainly Financials and many cyclicals, while the second leg down (September on) has been very indiscriminant. I anticipate that the next leg down will prove extremely harmful to companies with "too much leverage". While we are all familiar with the high leverage in the Financial sector, I believe that investors will be well served to try to differentiate between companies in other sectors. In an environment that will be tough on operating cash flow as well as realizations from asset sales, we could see many companies forced to sell equity to meet short-term obligations. While I have given this overall concept considerable thought over the past couple of weeks, I think that my efforts are only a start. I hope that my thoughts provoke others (hopefully with better accounting backgrounds than I have!) to start looking at companies beyond simplistic ratios. Haircutting assets, projecting cashflows, understanding the nature of and the timing of financial liabilities (i.e. beyond just "debt") and predicting the timing of equity issuance will allow the stock investor to avoid some of what could be more damage from this economic downturn.
Disclosure: No position in stocks mentioned.
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