23 Stocks to Consider During Global Deleveraging 23 comments
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Let me quickly admit that everything that follows could be wrong - one possibly shouldn't own ANY stocks or any assets. With that said, typically there are some stocks that go up even during the worst of bear markets.
The goal of this article is to consider how one should go about finding the best stocks to own when almost every stock is cheap by most metrics and certainly down a lot in price. It seems to me that the sellers, seeking liquidity at any cost, are selling what they own en masse and without regard to valuation. Surely there will be some babies in the bathwater.
Should we buy value?
Being cheap isn't too special these days. Using StockVal, I took the universe of all domestic stocks with market capitalization in excess of $50mm and found that 36% (1262 out of 3490) are trading below book value. While this anomaly is certainly more evident in smaller companies, 266 companies in excess of $1 billion market cap (24%) fall into this camp.
Now, as most investors know, book value (assets minus liabilities) isn't necessarily an indicator of the liquidation value of a company, but it's a good start. There are several factors that can diminish its value such as:
- Intangibles can't be recognized in liquidation
- Long-term assets are worth less than carrying costs or even replacement cost
- Inventory is worth less than carrying cost
- Accounts Receivable aren't collectable
- The company can have liabilities not reflected on the balance sheet
So, while we can't put a lot of faith in the market being cheap because so many stocks trade below book value, we can certainly take comfort that the current prices do reflect a lot of pessimism. What about other measures? Perhaps the most popular measure of stocks is the PE ratio. By any stretch, PE ratios are extremely low, especially when compared to risk-free assets (i.e. the 5-year Treasury is 2.6%, while most large companies have a PE of 13 or less).
Again, we have to be careful. Why? The "P" is known, but the "E" isn't. I had already written about the overly optimistic forecasts for 2009 earnings BEFORE this massacre. In that late-September analysis, I had suggested that EPS for 2009 would be about $80. Unfortunately, the contraction is likely to be worse than I thought, perhaps significantly. We might see EPS as low as $60. It's actually very difficult to project - there will be lots of "one-time" and restructuring charges that could disguise a plunge in "operating" earnings.
Interestingly, in the past four weeks, the 2009 estimate has come down from 104 to 97, but expect it to decline significantly. Even the 2008 estimate is likely still too high at 74. I had wrongly expected some growth in 2009 and believe that my updated expectations most likely account for this "shock".
Again, though, stock prices at the end of next year will be based upon expectations for 2010. EPS growth should be significantly higher than I had expected (the bigger the fall, the bigger the bounce), but they probably won't be anywhere near the $92 I had been expecting. I would estimate 75-80 at this point. So, using a simple long-term PE metric and assuming a 15 multiple, one gets to 1125 a year or so from now if things get "back to normal".
If one strips away this analysis and looks at the big picture, it is clear that stocks should have declined somewhat due to a deeper-than-expected recession, but probably not as much as they did (will operating EPS be lower than $60?). The trough earnings in 2001 was $39, down about 31% from the peak. The long and deep recession of the early 90s witnessed a 23% contraction. Sixty would represent a 35% decline from the peak. In the chart below (click to enlarge), you can see that long-term trend in earnings.
Three things stand out: For 20 years, the growth in the S&P 500 approximates the EPS growth now (despite a plunge in interest rates), the trailing PE is rock-bottom (hopefully) and the dividend yield relative to the 5-year Treasury (another value measure) is off-the-charts (as are many indicators).
What Should We Buy?
Again, the answer may very well be nothing. Certainly if the deleveraging isn't close to being over, almost every stock will face massive headwinds.
If one were to be extremely optimistic here, one would not take the cautious approach that I am about to recommend but rather wade in hand over fist and buy the stocks of companies that have high leverage of their own: Banks, General Electric (GE), Industrials with lots of debt, etc. Unfortunately, I have a feeling that the forces that be aren't likely to quickly recede, and suggest a more cautious approach.
While the screen I am about to convey captures only some of the attributes investors should seek, it is a good starting point. Here are some essentials in my opinion:
- Sales aren't easily deferred
- Strong balance sheet
- Low capital Intensity
The first point is this: How essential -- NOW -- are the products or services of the company? My screener won't help me on this one, but consider whether buyers can operate their business without making purchases. One that jumps out and isn't on the screen would be Automatic Data Processing (ADP). I believe that there are some companies that could actually see IMPROVEMENT in their business due to the environment (or certainly gain share).
The second point requires a lot of work. A balance sheet can be "strong" by not having a lot of debt, perhaps none, but there is more. How much cash is there? Are the inventories too high? What about the AR? Is their equity mainly "intangible"? If they do have debt, is it due in the next few years?
The final point is that some companies have to spend money just to keep the doors open, even if sales are plunging. The DRAM industry is a great example - lots of CapEx and rarely any profits. With "capital preservation" a key theme for companies as well as investors, one should be very careful about companies that have high CapEx requirements (or that require additional debt or equity infusions).
OK, so now what? The stocks below may fall into the category of the best stocks to own during global deleveraging, but there are no guarantees that they will rise. The supply of stocks will probably be going down (bankruptcies), but so will the demand (mutual fund redemptions). Still, professional investors will, for the most part, have to own SOME stocks. If the environment remains tough, here are some that I expect will benefit at least relatively:
(click to enlarge)
For the third time, allow me to hedge: This is not a "buy" list, but rather an "investigate" list.
I do believe that some of these stocks could hold on well as they seem to be much "safer" than the typical stock, yet very oversold. This is what I did:
- Market Cap >$1 billion
- P/B < 1.5
- Tangible P/B < 2.5
- Total Debt/Cap < 25%
- Leverage < 2 (Assets/Equity)
- CapEx/Sales < 5%
- Positive 2009 expected earnings
I wanted to restrict the market cap - there are many others that would make this list and I am happy to share those with anyone interested. Keep in mind that small-caps can really suffer immensely when liquidity is contracting, as it is now.
I didn't want to restrict P/TB to give-away levels, though some do make the list. The leverage constraint gets around non-debt liabilities being high. Finally, while some of these companies may indeed show losses if the economy deteriorates even more, I didn't want to start off with losses being expected.
So, the list is fairly broad in terms of the different economic sectors. Not surprisingly, Tech seems to be over-represented. I have followed Zebra Technologies (ZBRA) for many years and lost interest due to the lack of growth.
Still, consider that they sell a lot of consumables and that their printers can wear out. KLA-Tencor (KLAC) and Lam Research (LRCX) seem extraordinarily inexpensive with tremendous resources to wait for their customers to buy again, though some of them will need to do so.
I wonder about Nvidia (NVDA) - it sure is cheap. Their competitive position in the middle markets may be weakening, but they are the technology leader in graphics. AVX (AVX) is a stub company (Kyocera). One has to think that their long-term position in the industry could be strengthening as Kemet Corp. (KEM) and Vishay Intertechnology (VSH) head for possible bankruptcy.
With that in mind, be careful with Avnet (AVT). More than 1/2 its equity is in inventory. It may be price-protected in normal times, but these aren't normal times. It has a lot of exposure to KEM and VSH. AR exceeds 75% of equity.
Looking at the other sectors, it would seem like NBTY (NTY) could fit the bill, as vitamins are deemed relatively essential to many consumers. I haven't been a fan of King Pharmaceuticals (KG) since doing some extensive work on the company in 2001 and question the ability of management to effectively deploy its massive wad of cash.
Magellan Health Services (MGLN), on the other hand, has a lot of qualities that cautious investors should seek, including having an "essential" service for its customers and highly recurring revenue. PSA should do well, though it seems expensive in some regards. Its balance sheet is phenomenal.
The retailers are a tough call. I like value-oriented brands and retailers due to what I view as a replacement cycle of sorts. Remember, these companies have catered to pressed consumers for a while now (gas prices). Additionally, there could be some trade-down. I don't have any comments regarding the materials or industrials companies, but they could be those babies in the bathwater.
So, this screen has the goal of identifying companies that may offer some protection from further economic deterioration due to a combination of valuation and financial risk. As investors begin to make sense of this massive change in the landscape, I would expect that we will see a move towards companies viewed as defensive.
While an industry can be deemed defensive, often the valuation leaves it exposed on the stock price front. These stocks hopefully have valuations low enough and a superior risk profile relative to the market in general.
Disclosure: Long COLM
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This article has 23 comments:
KEM is in trouble. It has a highly leveraged balance sheet:
$394M in debt vs $35M cash.
Net debt is $359M vs $38m market cap.
Operating cash flow is MINUS $11M
Free cash flow is MINUS $53m
VSH is financially stable:
$607M debt vs $586M cash.
Net debt is $21M vs market cap $720M.
Operating cash flow ttm = $360M
Free cash flow = $216M
Net income is from non-cash writeoffs.
I don't even follow KEM and I knew your analysis was wrong. Five minutes of work and I can quantify why you are grossly misleading to lump KEM and VSH together. I don't appreciate wasting my time correcting your faulty analysis.
I recently pegged gold as a major sell, suggested healthcare reits might get pummelled, and pointed out a major pricing discrepancy for a bond ETF. It's not necessarily the conclusions, but the thought that goes into them that count. Rather than focusing so much time on criticizing, as you seem to do, why don't you add something to the discussion.
Basehitz, sorry to waste your time. While you are correct that KEM is clearly headed for bankruptcy, it is less clear for VSH. I suggest that you dig a little deeper and not be so quick to jump on others. You might have rather asked me to justify my position. Then, I would have told you that I have followed this industry closely for 8 years and I never would have expected KEM, which had a pristine balance sheet but a flawed manufacturing strategy, to ever go bankrupt. Then, I would tell you that VSH has gargantuan inventory and AR. Yes they have cash, and they aren't in imminent danger, but they have a lot of debt and will have problems rolling it over. The company lacks future leadership as well.
I'm really getting tired of doing your research for you.
You say "I would tell you that VSH has gargantuan inventory and AR."
Here is what actually happened:
Accounts Receivable:
FY 12/05 AR $389m vs Annual revenue 2.3B in (AR = 16.9% rev)
FY 12/07 AR $468m vs Annual revenue 2.8B (AR = 16.7% rev)
Q 9/08 AR $488m vs $774M rev (=$3.1B run rate) (AR = 15.7%)
Conclusions: AR as % of revenue is actually LOWER NOW than in past 3 years.
Inventory analysis:
FY 12/05 Inventory 488M vs Annual revenue 2.3B in (Inv = 21.1% rev)
FY 12/07 Inventory $583M vs Annual revenue 2.8B (Inv = 20.8% rev)
Q 9/08 Inventory $589M vs Q rev $774M (=$3.1B run rate) (Inv = 19.0%)
Conclusions: Inventory as % of revenue is actually LOWER NOW than in past 3 years.
Reality is the EXACT OPPOSITE of what this “analyst” is trying to sell.
Hey Alan, the SEC frowns upon “analysts” posting misleading information about the value of a company. Are you an incompetent or a fraud?
HEV - A newer lithium battery manufacturer .. Too young and untested. Great yoy, Seems to be trending between about $6 and $8, and is presently at $7 and moving towards its lower bollinger band.. At least it isn't tanking with the market.
SHY - Lehman Bros Short Term Treasury Bonds Index. It actually is trending up..(There's something novel!)
Pretty disappointing...
jegan ;-)
Frankly, it is irrelevant what their position was in 2005 as sales were growing rapidly. Do you even know this company? Have you ever heard them explain away issues? Are you aware how opaque they have historically been? I used to have to beat on Grubb to get information that shareholders deserved to have at the time of an earnings release: Cashflow and balance sheet metrics.
I am not sure why you have such a bug up your posterior. I made a point that AVT is at risk due to big exposure to KEM and to VSH. I have no position in VSH, but I certainly don't want to throw ideas out there (AVT) and not share my deep concerns about their customers. Perhaps you and I don't look at things the same way, but I am neither fraudulent nor incompetent. I continue to believe that in a sustained downturn (which is kind of what my article is addressing - risks), VSH could end up in bankruptcy (1 or 2 years out). Again, who expected KEM to be in these dire straits? Just two years ago, that company had $500mm in equity ($400mm tangible) and $100mm in debt (but $168mm in cash). In any event, I believe that VSH could actually lose money in the coming quarters as they face extremely sharp pricing declines. I believe that the market won't allow them to issue debt or equity. They recently paid off their convert. If I were going to suggest that someone invest or to invest myself in betting on their failure (which I am not), I would make sure that I am comfortable with the covenants.
So, if my use of the word "possibly" falls outside reasonable interpretation of what could happen to a company with high inventory, high AR, limited financial resources during a credit crunch and earnings that could head south quickly, I apologize. I do stand by my view that AVT is likely to be viewed negatively for its exposure certainly to KEM and most probably to VSH. AVX on the passives side and so many other semi companies on the Siliconix business have far superior capital structures that whether or not VSH survives this crisis, it is going to be very painful for the company's results.
Let me recap. . .
First you make an unsubstantiated claim.
I challenge you.
You make financial statement claims that I prove wrong.
You think I've got a bug up my arse.
I won't bother you any more. Facts can be a stubborn thing. Sorry to get you so upset.
At Vishay I see strong cash flow, aggressive expense control, and cash roughly equal to debt. Recent losses have been goodwill writedowns, noncash in nature.
The casual mention of Vishay as a bankruptcy candidate does not look good to me.
I challenge you on your contention that KEM is an imminent bankruptcy candidate and invite you to listen to their last conference call and earnings report. Here are some points for your consideration:
Positives:
1)KEM is less reliant on the consumer market.
2)Improved gross margin from 11% to 12% Q over Q.
3)Tantalum business has a higher margin and book to bill holding at 1 as of today.
4)Finished the quarter with sales stronger than expected even with their Distribution customers.
5)Looking at increasing tantalum capacity as their was some unfulfilled demand from Asian customers.
6)KEM may be gaining market share in this business given the current book to bill.
7)Seeing working capital improvement.
8) Seeing Average Sale Prices (ASP) improving across all lines (except Ceramic)
9)Expecting margins to improve in both the dec Q and the March Q despite expected lower sales due to further cost improvements.
10)As the US$ has strengthen, the foreign exchange is favorable in terms of margins as the cost structure is based in Euros, Mexican Peso and local Asian currencies while 70% of sales are US$ denominated.
11)Expecting CAPEX to drop in the next two quarters as they are in the downward slope in terms of capex and this will improve cash flow.
12)Expecting further improvement in account receivable collections, only a few customers were late but already started paying.
13)Management would love to be able to buy shares in the open market at these prices, but their lawyers have prevented them from doing so because they are still not done with all the initiatives they are contemplating to build shareholder value and shoring up the balance sheet....they expected a lot more operational improvements coming.
14)Last but certainly not least, the assets they sold to VSH generated $28 million of gains from what they had them in the books....and they didn't even sell the actual plant (listen to the call). Tangible book value per share is $2.88 and as evidenced by this sale, some assets in that tangible book may have a higher fair market value. So in terms of the value of the assets minus their liabilities at a price of 50 to 60 cents a share, armagedon is priced in. As I mentioned on the conf call, the value of one asset sale almost equals the value the market gives the entire company.....ridiculous...
Negatives:
1)US and Europe experiencing marked slowdown in the automotive industry.
2)Ceramic business showing lower volume but higher margins....continued weakness in prices for this business expected in the range of 4% to 7% for the Dec Q mainly because of oversupply in Japan. This business is expected to improve in a year's time, but the fact that KEM has been retreating for this business has helped.
3)Expecting a decline in sales from 3% to 7% Q over Q for the Dec Q, but expecting improved margin and earnings results.
4)Higher tantallum powder prices expected to increase for next year, but expecting to mitigate some of the increase through engineering and will pass along the balance of the price increase to customers.
On Oct 29 06:46 PM Alan Brochstein wrote:
> Tom, I erred in lumping them together when I didn't mean to equate
> them at all. KEM sure does look like an imminent candidate. I expect
> that if this downturn persists into 2010, VSH will face tremendous
> pressures. I believe that AVX is much cheaper and safer. Note the
> pre-announcement - sales are now in decline year-over-year. I don't
> know how well you know this company, but I know them fairly well
> and don't trust them. There are too many cheaper and better companies
> out there in my opinion.
I really suggest you go through the news flow and conference calls before calling for bankruptcy based on assumptions....there is real money from real people at stake.
KEM sold the assets of a Wet Tantallum facility to VSH for $50 million ($35 million cash and $15 loan from VSH) and with this money the retired the $40 million note. In addition, the refinanced the loan with Unicredito that was due this year to a 4.5 year loan with semiannual installment. The stock is under $1 just as many small caps have destroy during this massive market deleveraging, but you should give another look....it could be a homerun.
On Oct 31 06:38 PM Alan Brochstein wrote:
> Babysamalot, that's a lot of interesting information, but here is
> my question: Did they address their short-term debt? Do they have
> the ability to refinance it? Anytime I see a company with negative
> cashflow from operations, low margins, short-term debt and a stock
> price below $1, I assume that it is a bankruptcy candidate. I could
> be wrong...
thanks for your interest. First of all, although in the article you only use the word "possibly", you also used "almost certainly" and "imminent" when describing KEM's chances for bankruptcy when replying to other people's comments here. Hence my desire to clarify a these points.
I never did understand your point in the article regarding AVT's exposure to KEM and then mentioning that AVT had 75% of equity in A/R. You lost me there because AVT is a distribution customer KEM, so KEM is the one with exposure to AVT receivables. If your point was to highlight that KEM may be a big supplier to AVT, then yes there would be a risk that AVT loses a supplier but I would not call that exposure (exposure to me usually denotes credit risk) as there are plenty of suppliers that could replace KEM for most capacitor products.
Anyway, you raise very good points regarding the short-term facility due to mature in April 2009; maybe I can put to rest some of the concerns you rightly bring up. First, not only has UniCredito already committed to the refinancing of this facility through the signing between both parties of a Letter of Engament and Term Sheet, but this facility is also made reference to in the preamble section of the Loan Agreement for the facility already refinanced. It says that the factoring agreement is being negotiated as of the date of the Loan Agreement (check the 8k filing). In my view, the riskier refinancing/commitment was the facility already done. Second, you point out that the risk is the possibility that UniCredito might not be there to make good on that commitment. Besides the fact that there would be legal implications against UniCredito if that were to happen (depending on the wording of the term sheet), UniCredito is the largest lender in Italy and I don't think that Italy would let it fail. In fact, the government is already in talks to buy 10% of the bank and UniCredito is close to completing a capital raising effort that has already attracted capital from various sovereign wealth funds. Finally, both the CEO and CFO of KEM mentioned on the call that they are currently working on the facility with UniCredito and that they fully expect it to be done in the coming weeks or months.
So, yes it is a risk, but not the high level of risk you elude it to be (in my opinion) given what has already transpired both with KEM and the credit markets. And at any rate, this risk and others have been priced into the stock many times over.....oh, and don't forget, there are over 11.3 million shares (14% of shares outstanding) short as of Oct 15 for a stock with a normal daily avg volume of 700k shares. So at this price level, given the obstacles KEM has already been able to overcome, given the obstacles still out there, and the expectations laid out in the cof call....the real question is: who is running with more risk to their position, longs or shorts?
On Nov 01 01:40 PM Alan Brochstein wrote:
> After replying to you, I went back and reviewed the transcript (including
> your line of questioning). I ask you this: What happens if Unicredito
> fails to deliver by April of 2009? How likely is the market to worry
> about it (you should check out the chart for that Italian bank).
> I am not "calling for bankruptcy", just highlighting a serious situation.
> Recall, I said "possibly", and it wasn't my thesis in writing the
> original article. The point of this article was to identify systematically
> companies that were appropriate to consider during a very tough economic
> challenge. My awareness of some of the balance sheet risks to one
> of the companies that made the cut forced me to assess the exposure
> to KEM (and VSH). I don't know if KEM will actually go bankrupt or
> VSH eventually, but I do believe that the market will be very concerned.
> Maybe KEM is a fantastic investment now - who knows. I wouldn't "bank"
> on it, though, as the company is likely toast if Unicredito doesn't
> deliver on its commitment to refinance the remaining short-term debt.
> Look up the definition of bankruptcy - being able to meet your liabilities
> and taking a legal action to remedy the situation. On paper, the
> company may have a lot of value, it's just a question of who ends
> up with it if they are unable to meet their short-term obligations
> in 2009. In this environment, you would be foolish not to consider
> an investment in KEM as very high risk (though possibly extremely
> high reward).
On the AVT connection, I think that I did err in the way I approached KEM from the AR angle. Thanks for pointing that out. Giving it further thought, I would suggest still to approach AVT cautiously. It has extended a lot of credit with respect to its total equity value (perhaps not so much relative to sales). In a slowdown such as we are experiencing now and in conjunction with a severe credit crunch, it could be vulnerable to collection issues. Historically, I believe that suppliers have price-protected their distributors, and this is where I believe that the exposure to KEM (and VSH) could bite AVT. In any event, AVT has a high amount of inventory relative to equity as well. The point I was trying to make is that there are strong balance sheets and there are bullet-proof balance sheets. While AVT seems to have a strong balance sheet (as represented by making my screen's cut), I tend to think that the metrics don't capture the reality. Thanks again for your comments.
On PSA, your table lists a price of 23.64 and a P/TB of 0.5.
This seems inaccurate. As far as I can tell the stock has always traded in the range of $70-$80. Is the table inaccurate, or am I missing something?
When I mentioned the A/R, this had nothing to do with KEM. As a distributor, AVT has extended significant credit throughout its customer base. In a deep recession, the collectability will be challenging.
I mention these points because AVT made the list but doesn't deserve consideration in my opinion. The balance sheet is tainted, again in my view.