Survival Kit for a Credit-Starved Market

Unless you’ve been on hiatus to Borneo, or in a coma, you know credit markets are damaged and we’re sliding into a global recession. The former didn’t cause the latter (entirely), but if one doesn’t get fixed the other will get worse.

The bear market blood bath has been costly to one’s pocketbook, sleep and sense of humor. Sadder yet, was the incredible wealth destruction caused by a casino mentality and egregious executive strategies of a “modern” western banking system. Way to go guys!

To label a “derivative” or “credit default swap” as a creative financial product is an understatement. I can live with the fact our insurance industry is actually the bond market dressed in drag. But it’s irksome as hell knowing some investment bankers are really devils in Armani suits!

It just goes to show not everyone with an MBA or PhD after their name is a guarantee of righteousness. What’s an investor to do?

It’s impossible to know how long this nonsense will be with us, but survival skills are handy when the bear’s hot breath lingers. As the rules of engagement change, so must attitude and tactics.

Investors need to be pragmatic not dogmatic. Here are a few ideas from our playbook along with two slick investment analysis tools we use to keep out of harm's way. Think of it as common sense meets guerilla warfare.

Take a good hard look at the macro picture: We hear lots of folks comparing potential of this recession to the Great Depression of the 30’s. Indeed there are some similarities; bursting asset bubbles tainted by creative hubris and cheap capital, wreaking sloth and surfeit upon the masses.

Why not compare it to the fall of the Byzantine Empire too? The only difference between the Dark Ages and now (besides a lack of constitutional law and many years) is they didn’t have computers.

It pains our sensibilities to see executives compensated with TARP funds or know that guys like Dick Fuld (Lehman Bros.) and Gerry Killinger (WAMU) got paid big bucks to trash their businesses. There is something fundamentally wrong in rewarding an emperor for incompetence.

Yet, casting blame entirely on Wall Street hot-shots and their boards is an exercise in futility. Sure, they profited immensely from their “ingenuity”, but as we’ve learned, some structured products fall farther from the tree than others.

Learn From History: Recessions happen and for a variety of reasons. In 1973, stagflation reared its ugly head, thanks to OPEC quadrupling oil prices and an expensive Vietnam War budget. Federal Funds Overnight rates (FFO) Sept. ’73: 10.78%

1980-82 came on the wake of a revolution in Iran (new regime was very inconsistent with oil exports). In the US inflation was rampant and monetary policy was tight. FFO rates June ’81: 19.10%

In 1990-1991, industrial production slowed as high labor costs pushed jobs overseas, rising unemployment here. Budget deficits (from Gulf War) ushered in sluggish GDP. FFO rates Dec. ’91: 4.43%

2001-2003 began with excess capacity (and high inventory levels), then sucker-punched by 9-11 and numerous accounting scandals: FFO rates Dec. ’03: 0.98%

2007- ?: Ghosts of easy credit (2001- ‘06) return to haunt viciously. Massive leverage became massive problem as lenders & borrowers took considerable license with their balance sheets. Learning curves are steep, but this one’s a doozy. FFO rates Nov. ’08: 0.38%

In most recessions, profits and earnings contract, which is normal. Top-line growth (sales) shrinks and cost-cutting is what helps the bottom line. What makes this recession so different?

Business has been cost cutting for years and they are now hacking at the bones (i.e. jobs). Also, credit is scarce and companies can’t borrow which means they can’t grow the enterprise, let alone maintain it.

Good News: Cheap oil prices help tremendously in that they don’t add an extra “tax” to the economy. OPEC doesn’t look to be in any position to raise prices unilaterally, because demand has fallen off a cliff. Sure, they could cut production, but these guys have cheated on quotas for years. The only real near-term catalysts to push oil prices higher would be geo-political issues or a man made catastrophic event (i.e. terrorism).

Bad News: The unemployment situation isn’t cheerful and anecdotal evidence suggests it will get worse. We aren’t economists, but it wouldn’t surprise us to see 8.5% or more unemployment by second half of 2009. And, if those spoiled labor unions don’t pull their heads out of their you-know-where, it could go much higher.

The political process in this country needs a slap upside-the-head too. We’re glad to see Obama getting face time (announcing key posts in administration), but he’s gonna have to hit the ground running.

In contrast, VP Joe Biden’s Dec. 23 interview talking up the Obama stimulus package was dreadful. He did not say anything we don’t already know, and he offered a very dour view going forward. Perhaps the Obama team is trying to lower expectations?

Then, during the same interview, Biden proceeded to extol the virtues of their massive stimulus plan, which will involve incredible amounts of new spending by government. This, he claimed, would help the middle class pull the economy out of its funk. He was vague on the details except to promise there would be no pork attached to these funds. Gee, thanks for the clarity Joe.

Mr. Biden will never be a threat to win a Pulitzer, but now that his tasseled loafer has finally managed to wiggle its way into the Executive Branch of Government, he should at least make an effort to be on the same page as his boss. We preferred Joe as a piece of furniture in the Senate.

The American people are desperate for leadership and if New Deal policies are the best ideas these folks can come up with, nothing will get fixed. It’s bad enough that Republicans couldn’t write meaningful legislation while they ran the store, but listening to blowhards like Sen. Chris Dodd, Rep. Barney Frank and Biden try to talk themselves out of a paper-bag doesn’t help matters much either.

How these guys managed to become chairmen or senior members of powerful banking, finance and foreign policy committees is beyond us.

Worse News: The thought of Joe Biden becoming President! Seriously though, the credit markets are still in very bad shape. Banks have been hoarding the cash received from Uncle Sam and they are not lending!

In addition, there are still billions of dollars in Auction Rate Preferred Securities floating around unredeemed (auctions have failed since February). LIBOR rates may have come down, but as long as these ARPS remain frozen, it’s difficult to see credit markets functioning normally anytime soon. The Fed may have orchestrated low rates, but the blood is not getting to the muscles that need it most.

Look at the Management Team: Good management is the difference between a decent competitor and a great one. In a slowing economy, even the best run companies are forced to adapt a new game plan. Every industry has different issues and we start by reading the management’s discussion and analysis section of a company’s 10-Q and 10-K filings for clues.

Some managers articulate better than others, but these days, consistency helps a lot. In a slowdown, everybody feels the earnings pinch. It’s easy to understand high raw material costs affecting a whole group, but if one company says “Hey, we had an inventory problem and this is how we plan to fix it” and a competitor says “Well, sales were impacted by rainy weather and fewer selling days in the period”, which story should you believe?

That depends on the industry and business cycle, but better managed companies don’t gloss over an earnings miss by blaming the calendar or precipitation (tornadoes and hurricanes excepted).

Learn to read financial statements: You’d be surprised how many active investors buy stocks with little or no knowledge of the “numbers”. Sure, they look at price ratios, return on equity, etc., but in some cases, it doesn’t tell the whole story.

Back in the old days when Jack Welch ran GE, we were constantly amazed how the company always met their numbers each quarter. Given such diverse and disparate units (appliances, plastics, aircraft engines, financing, etc.), this would seem tough to pull off on a regular basis.

How did ‘ol Jack do it? Did he dip into the pension fund? We wouldn’t know nor are we accusing GE of monkey business, but the point here is that managers have many legal methods to “massage” an earnings report.

If you really want to put your finger on the pulse of an industry and health of its players, look first at earnings quality and the cash-flow components used to create them. In a credit starved market such as this, we believe company managers are shifting their priorities from revenue growth to capital preservation.

Balance Sheet: We see several trends emerging in corporate balance-sheets these days.

• Current assets are taking longer to be converted into cash
• Accounts receivables are rising faster than sales
• Rising pre-paid expenses (these don’t get turned into cash)
• Huge jumps in accounts payable

What does this mean? Customers are not paying promptly either because they don’t want to or can’t. Larger amounts of non-operating “assets” are being thrown into the broom closet and companies are stretching out their payments to vendors.

Income & Cash Flow Statement: Non-cash accounting adjustments or “fluff” is on the rise too. Some noticeable signs of late:

• Accelerated depreciation without any significant change in capacity
• Heavy reliance on changes in inventory, accounts receivable, deferred taxes, bad-debt allowances, etc.

Thus, we are seeing more and more earnings reports propped up by balance sheet maneuvering rather than actual cash-flows generated from operations. As managers pull more levers to build their numbers, investors need to keep a close eye on the cash.

Trust your instincts, but think outside the box: We use two powerful analysis methods to divine earnings quality and cash-flow.

1. The Dual Cash Flow Method
2. Accrual Ratio Analysis

Dual Cash-flow analysis tracks changes in the relationships of key reported financial data over a period of time. The DCF screen we built is based on the innovative research of Harry Ernst and Jeff Fotta (1995).

DCF is designed to compare the difference (or spread) between operating cash-flows and balance sheet cash flows. By separating real cash produced by operations from “cash-flow” generated via accounting adjustments, we get a good idea of the earnings quality.

• We like to see operating cash-flows rising and balance sheet cash-flows declining

Equally effective is a novel accrual analysis method developed by Richard Sloane more than a decade ago. The accrual ratio helps verify the trends in non-cash contributions to the earnings.

• Rising accruals indicate a heavier reliance on non-cash assets to boost earnings
• Declining accruals suggest better quality earnings

When combined, these two unconventional methodologies provide remarkably accurate and predictive analysis. Companies recently displaying healthy or improving earnings quality include tech titan International Business Machines (IBM) and household products maker Colgate Palmolive (CL).

A few names not passing muster lately are Nike (NKE) and Dryships (DRYS).

Managing risk in a crazy environment like this requires an awareness of the macro issues and the proper tools to identify opportunities and avoid calamity.

We have long argued that the “quality” of earnings is more important than the amount of earnings produced. Thanks to keen-eyed folks like Ernst, Fotta and Sloane, an investor’s chances of survival increase dramatically.

Note: Seeking Alpha contributing author Mark Barath wrote an interesting piece on Sloane’s accrual research and it’s a good read.

Disclosure: Author is currently long CL.

Comments

[John Cordes:]

You could have summed up your comments in the last 250 words and saved us from the onslaught of mixed metaphors and personal opinions.

2008 Dec 31 08:42 AM