My major investment theme this year is to "beware of big bad balance sheets", which I described in late December. I mentioned General Electric (NYSE:GE) specifically, but I also followed up with a review that described the company as a "value pit" on 12/29. As the stock rapidly descends into single-digit land, I stand by my contention that this will be a tough year for GE investors. I didn't offer a prediction of how low I expect it to trade, but I can argue that the stock could fall another 50% and still be too expensive given its balance sheet burdens.
As I listened to CEO Immelt on CNBC following their earnings last month, I couldn't help but feel that he just doesn't get it. To talk about all that cash on the balance sheet as justification to pay a dividend on the common is ridiculous, as that cash is more than encumbered by the $693 billion in Liabilities on the balance sheet. With leverage at 15X (A/E), and tangible leverage at something like 100-1, GE is an accident waiting to happen in this economic environment.
You can review my negative arguments by going back to the article from late December, but the key points:
- Most of the economic value of the company belongs to the debtholders
- Leverage is extremely high
- Tangible equity is tiny
- Core business at risk due to economic environment
- Weak balance sheet prevents acquisitions and share repurchases and suggests dividend cut
The metrics that I shared worsened in Q4. At the end of the day, there appears to be some belief out there that GE is anything but just an acquisition-oriented, debt-issuing, borrow short/lend long company. I am not sure why. Perhaps people are impressed still by six-sigma despite the fact that so many other companies have adopted the process. Maybe folks are excited that they spend 2% of revenues on R&D. Whatever the case, GE is extremely overvalued if one looks at it as part Financial and part Industrial. S&P actually classifies it as an Industrial, so I will stick to that sector today as I describe a strategy that I think will work well for long-only investors: Buying the good balance sheets.
Let me suggest that while GE is one of the worst, it isn't alone. So many of our largest and "most respected" industrial companies have built unsustainable business models (note to Obama administration: why are you including GE and Caterpillar (NYSE:CAT) CEOs in your council of outside advisors?). When I look at the members of the S&P 500 Industrial sector, it doesn't take me long to spot the companies that drank from the debt fountain to excess: GE, United Parcel Service (NYSE:UPS), United Technologies (NYSE:UTX), Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), Honeywell (NYSE:HON), General Dynamics (NYSE:GD), CAT (especially CAT), Northrop Grumman (NYSE:NOC), Deere (NYSE:DE), Waste Management (WMI) and more. Some of these companies have built captive finance units, some have repurchased a ton of stock and others have been highly acquisitive. The net result is significant debt and/or other liabilities well in excess of their liquid assets or earnings capacity. Low interest rates have hidden the risk to the companies (debt service coverage ratios are OK looking backwards), but that is changing as these companies move to lock in longer-term financing at higher rates.
The smaller companies in general in the Industrial sector have been significantly more conservative than the big consolidators. They haven't had to boost ROE by repurchasing stock. Their organic growth has been strong enough that they haven't had to buy additional growth.
As it turns out, the big guys overpaid, and they are now stuck with deteriorating businesses and loads of debt. I expect that the prices and valuations will continue to shrink for many of these companies. What is harder to predict is what might happen to the industrials in relatively better shape. I am including a list (click to enlarge) of all Industrials with market caps in excess of $1 billion that meet strict valuation and balance sheet parameters. I expect that we could see rotation into some of these names as investors begin to better understand the lack of value in the equity of some of these larger companies. I am not sure if these stocks can actually rally with this rotation, but I surely expect this list to outperform the sector and perhaps the overall market.
I took the 151 Industrials with market caps in excess of $1 billion and applied the following to reach the 15 names:
- PE <18
- Price/Tangible Book Value <4X
- Net Debt to Cap <10%
- Total Liabilities/Current Assets < 1.8X
- Total Liabilites/EBITDA < 3.5X
I would first point out that below $1 billion, there are another 45 names for any of you who prefer Small-Caps. The list that I have shared isn't buy recommendations but rather a starting point. I actually follow closely only Copart (NASDAQ:CPRT), which is the leading marketer of salvaged automobiles (a green play!). While their growth has slowed abruptly and estimates have dropped (maybe not enough), their franchise remains intact. The stock bounced off of big multiyear support at 24 and is one I am considering buying.
While I remain bearish on the economy and stocks and would expect that the smaller industrials with strong balance sheets will "hold up" better during challenging times though most likely decline nonetheless, bulls should be even more enthusiastic about the concept. Companies with small debt burdens and strong business niches should thrive when the economy turns. When investors become more enthusiastic about buying stocks, I would bet that they seek out companies like these as opposed to plowing into the debt-burdened companies that will be issuing stock for years to come to deleverage their balance sheets. While many like to talk about "how strong" GE is in certain markets in which it competes, I would argue that many of these companies are leaders in the small niches in which they compete as well. Bigger is not always better.