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By TMFKMHinson
January 20, 2010

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Just an initial note here... not one original thought in the following post. This is kind of a note to myself, so feel free to ignore my rambling. If nothing else, I can look at it in a couple years and laugh at dopey I was.

I've been geared toward raising cash as the market has risen and the economy confuses me, and it's gotten to the point where I don't even look very hard at individual companies anymore. I'm almost immediately dismissive of every stock I see, and chalk each one up as "not cheap enough" even though I've put almost no time into valuing anything lately. Buffett says he spends 10 minutes a year thinking about the economy, and I saw a Berkowitz interview recently where he said any time is a good time to invest because there's so many equities something always offers a compelling value. Based on that, I think I've fallen into a psychological trap to not be digging into anything lately and to be geared so heavily toward cash. If the masters say they can't predict the market, why do I think I can?

So I've tried to crystallize my thinking on paper... ok, it's not my thinking, but I've tried to crystallize the important concepts of other people who's ideas resonate with me (let's hope biased assimilation isn't too huge a factor here) into a few paragraphs to help me get back on track. The basic outline of my notes to myself is as follows:

I. The economy - loads of uncertainty, impossible to predict, why I shouldn't try
II. The overall market - where the overall market is in context of the economy
III. Checklist - my simplified checklist to run companies through given the current market and economic uncertainty

-------------

I.

Massive uncertainty.

Still have a lot of deleveraging in front of us. Normally that's deflationary and results in low interest rates. We're also running huge deficits, and it's questionable who will finance those. That could result in high interest rates. Fed has promised to stop buying up mortgages after March (driving up rates), and other stimulus scheduled to dry up in the second half of 2010. Massive tax increases are scheduled for 2011 (and beyond?). Unfortunately, these are hardly feasible with double digit unemployment without killing growth and pushing the economy back into recession. The alternative is continued stimulus, which can go on for an extended period of time, though the returns diminish over time as only so much future economic activity can be pulled into the present, and the cost includes higher government debt and higher future taxes... meaning higher interest rates and lower growth and a generally higher level of pain simply kicked down the road for now with perhaps another asset bubble or two between now and then. Look at Japan... two decades of stimulus and low interest rates, and they have nothing to show for it except 3x the government debt-to-gdp ratio and an economy poised to collapse on even modest interest rate increases, which are inevitable due to an aging population that is no longer saving and can no longer provide a domestic source of financing for that monster deficit. The bottom line is... some economic metrics appear to be stabilizing, but these are buoyed in part by massive government spending (housing stimulus, auto stimulus, buying mortgages, low interest rates, infrastructure spending, etc.). Absent that stimulus, organic recovery doesn't exist, and we're in for some economic trouble... it's only a question of when and how big.

Simplifying many issues here... doesn't matter, since the only point of this paragraph was to remind myself that I have no ability to predict inflation or deflation or both or one then the other or neither. Timing would be an even more outrageously impossible prediction. It's over my head, and any investment decision made based on a prognostication of these considerations is a pure gamble.

II.

Back to basics.

Three ways to make money in stocks:
1. Earnings Growth
2. P/E Expansion
3. Dividends

Looking at these criteria in relation to the overall market:

Earnings Growth - Consumers are deleveraging and spending less, and higher taxes and higher interest rates are ensured at some point by the massive deficits we're running right now. This means lower earnings growth (overall) and a slower recovery than in recent recessions. The only way to avoid this fate is if we're hit by high inflation sooner rather than later, but this creates low quality earnings growth, increase the discount rates used to value stocks and kills P/Es. So the range-bound market ends sooner, but with lower P/Es. The flip side would be deflation. The government has fewer tools to fight deflation, and lower revenues on fixed costs that are slow to adjust would kill a number of companies and hit the overall economy pretty hard. Risk premiums would increase substantially as companies faltered, meaning lower P/Es on declining profits... a double whammy that we definitely want to avoid at all costs. This would tip us from a range-bound market into a full-fledged Japanese style secular bear market. Earnings must grow sustainably at some point to avoid this.

P/E Expansion - For long-term P/E expansion, the starting valuations matter. Today, the market is not cheap. Based on the true earning power of the market, most estimates I see peg it from $50-60/share for the S&P. That means a P/E of 19-23, or 25-50% over the long-term mean. Using 10 year average earnings, we're maybe 22% over the long term mean (at S&P 1,150). Long term P/E expansions don't start from these levels. We're more likely in the midst of a contraction of multiples, and mean reversion nearly always ends up overshooting the mean. To do so in a low growth environment means it will take longer than usual for earnings to grow enough to eat up the current premiums in market prices. The current range-bound market could be very long, unless strong inflation speeds the process up but causes P/Es to drop to a lower overall level due to higher discount rates meaning investors will pay less for them. Deflation would kill both earnings and cause P/Es to contract as risk premiums demanded increase.

Dividends - At current valuations for the overall market, dividends become key, often generating the bulk of investment returns in range-bound markets.

III.

How to invest when I want to hoard cash?

Checklist.

  • Dividends - could be all of the return on investment for an extended period of time. Don't have a hard floor on this yet, but I'll start looking around 4% or so to start.
  • Revenue - look for sales that come from non-discretionary or consumable products that force repeat purchases. Food, consumer staples, discount items, health care, standard business expenses, utilities might be good places to look... though not all of those meet the next criteria. Avoid big-ticket items, discretionary items, durable goods, etc. Want companies that will do ok without economic growth or stimulus, but will benefit if the recovery exceeds expectations.
  • Pricing Power - Be able to raise prices quickly in inflationary times and slowly in deflationary times. For me this means avoid any commodity companies, where the value of the company is decided by commodity markets, which I am unable to predict anyway.
  • Strong Balance Sheet - this is always a requirement, but in uncertain interest rate environment, make sure the company can pay off all debt in a few years with rock bottom estimates of cash flow.
  • Cost Structure - Look for a company that can scale its business relatively quickly or has a fairly light/low-fixed-cost business model to start with.
  • Valuation - again, always a requirement, but a more stringent one now. Ignore relative valuations since P/E are compressing, historical P/E ranges lead to value traps. Stick with absolute valuations, and demand a solid margin-of-safety.
  • Don't hesitate to buy good company at good price because of scary economic prognostications, but demand these qualities. High quality companies outperform even during slow growth or deflationary times (i.e. Japan). Ignore cyclicals, emerging markets, etc. Absent any suitable candidates, don't be afraid of cash (not a problem for me). Very low opportunity cost in cash during a range-bound market. (Current multiples indicate we're not on the cusp of a bull, so range-bound is most likely.) Also don't hesitate to sell at fair value.