Equity Markets De-Risking
The mid-point of September 2009 marked the one year anniversary since the fall of Lehman Brothers. Interestingly enough, since that period many stocks that experienced strong performance since March 2009 have started to experience substantial corrections. The market appears to be de-risking as many small and mid-cap stocks have taken major haircuts, while a number of larger capitalization stocks appear to have held steady, if not improved, illustrated by Exhibits I and II.
EXHIBIT I: SELECTED SMALL CAPITALIZATION NAMES
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EXHIBIT II: SELECTED LARGE CAPITALIZATION NAMES
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The US economy is facing both cyclical and structural economic issues which in turn has made market participants question the strength of the recovery. This may have led to a shift in risk appetite with investors rotating from higher beta, smaller names into larger companies that offer well recognized products, services, and brands with stronger balance sheets. These companies can presumably withstand further economic pressure compared to smaller companies that may have less dominant market positions and have greater financial leverage.
One big concern is the strength of the recovery and whether the US consumer will be a leader in it. It appears from reviewing economic data, financial media, economist opinions, and anecdotal evidence that this is unlikely to happen. As a result, it's easy to find many skeptics when it comes to equity prices. However, investors may be ignoring the ability of companies to manage the cost items of the income statement as well as the ability of companies to manage working capital accounts on their balance sheets, in essence enhancing their ability to generate cash and profits.
For example, while sales have dropped considerably for many companies, management teams have slashed corporate expenses to such a degree that SG&A has scaled down even more aggressively than sales declines. In addition, with many commodities and input costs declining, gross margins have been able to hold steady. Given the aggressive reduction in corporate expenses, stabilization in sales declines can have a very pronounced impact, even without the benefit of a V-shaped recovery.
Example I provides an illustration of how this can work. In 2008, Company X generated sales of $1B with gross margins of 40%. At the time, due to its scale, SG&A was $250MM resulting in EBIT of $150MM. Assuming there was no financial income or expenses, a 40% tax rate, and 100MM shares, Company X had EPS of $0.90. Now let's fast forward to 2009. Based on three quarters of data, investors can reasonably assume the metrics presented in Example I for 2009.
EXAMPLE I: COMPANY X
Due to lower commodity and input costs, Company X has managed to improve gross margins. In addition, perhaps there is less excess inventory relative to 2008 when the global meltdown occurred, resulting in companies aggressively discounting their products. With Company X controlling its inventory along with reduced input costs, gross margins have actually increased. Keep in mind that H2 2008 resulted in many companies and customers "shutting down" in terms of willingness to purchase just about anything. This was illustrated in the devastating GDP figures in Q3 08 and Q4 08. So with reduced inventory, reduced input prices relative to 2008, and customers feeling that the worst may be behind them, gross margins have improved. Second, Company X has reduced its cost structure at the SG&A level. While sales in 2009 will decline by 20%, SG&A has been stripped out by 30%, resulting in the same EPS despite a much worse economic backdrop.
This has become an issue for many market observers that note that earnings beats have been driven by cost cutting as opposed to top line demand. This may not be as large a problem, however, if even a mild recovery occurs. Example I projects that in 2010, sales may increase by 7.5% from 2009 levels. This is hardly robust growth from an anemic bottom. But assuming gross margins remain level with 2009 and SG&A increases by about 3% as work weeks and worker demand slightly increases, Company X - despite sales levels 14% below 2008 levels - can generate a higher EPS in 2010.
One thing investors should note is that PE contraction likely occurred in 2007 and 2008 such that Company X's 2008 EPS of $0.90 may have been valued at 6.0x EPS, making Company X worth $5.40 early in 2008. Perhaps as 2009 has demonstrated, a severe and complicated recession is what the US is facing as opposed to the Great Depression II and therefore Company X can be valued at 8.0x 2009 EPS of $0.90 or $7.20. This 33% gain may just be part of the normalization process from Armageddon to awful.
However, investors should question how 2010 EPS would be valued. Presumably things should be improving in 2010 and 2011 should have a better outlook as well. Would a 10.0x EPS multiple or 12.0x EPS multiple be warranted or plausible? Even if the market elects to value Company X's 2010 EPS at just 8.0x, the value of the stock would be $8.08, 12% higher than 2009 levels.
Example I is intended to solely provide a back drop for how investors may wish to analyze potential investments on both the long and short side. Indeed, if Company X's valuation rocketed from a PE of 6.0x to 25.0x and was still facing the same, weak future prospects, shorting Company X could make sense. However, across a number of stocks, particularly in the more volatile small and midcap space (the stocks that have acted like those in Exhibit I) which have fallen 20-50% from their recent peaks, market observers may be missing an interesting entry point.
Commercial Real Estate
Shorting equities in 2008 was a slam dunk which has led many pundits and financial media to spend considerable time on items such as levels of government debt and the impending commercial real estate ("CRE") collapse as investment themes for 2009-2010. CRE is a risk but may not be the market killer many fear. This is in part due to the wave of bank consolidation that occurred in the early 1990s through the most recent crisis. Basically the big banks got killed by CRE in the early 90s and actually learned their lesson. The big banks were killed by derivatives and more residential exposure while the smaller banks took on the CRE.
The problem is that CRE is held by regional and smaller banks which is why many have lagged the larger banks in terms of performance. Regionals don't have the capital market businesses that larger banks do, so they are stuck trying to rebuild capital reserves based on the yield curve. In contrast, those with capital market businesses have had the chance to rebuild capital faster given their ability to participate in the volatile markets. What could pose an issue is the new line that the government is drawing between Too Big to Fail ("TBTF") and everyone else. "Everyone else" are those that are holding a lot of bad CRE.
Successfully shorting these types of banks would require examining the CRE exposure of the many small and regional banks. Another possibility could be sifting through the FDIC's Troubled Bank list and finding suitable candidates. Shorting REITs may also be an idea to consider as the stocks have performed extremely well since raising equity in the spring. The risk of a complete failure for many REITs has subsided due to the equity raises. Those actions saved many REITs from the abyss and that, combined with a major contraction in credit spreads, benefited highly levered equities like REITs, propelling those shares. However, given expected occupancy levels, rents, and cap rates that still have not quite blown out, FFO valuation metrics may be ahead of themselves for a number of REITs.
Nonetheless, while many banks will continue to fail due to CRE and other economic problems, investors should note that the impact in terms of managing portfolios could be relegated to specific areas. The major banks control the lion's share of assets such that hundreds of bank failures may have very little overall impact compared to 20 years ago when assets were less concentrated. However, one theme that could play out is that as CRE impacts smaller banks, larger banks could benefit as the supply of available credit continues to contract, further strengthening the banks on the government dole.
Rent It, Don't Own It
US investors have already experienced our first lost decade, and simply holding on to equities since 2000 generated a much different return profile than what investors - and frankly the majority of investment managers - experienced from 1982-2000. Unless certain investments in one's portfolio are designated as extremely high conviction and offer multibagger possibilities, enduring high levels of volatility can be costly. This is not advocating a holding period of just days but investors should remain nimble and focus on both the long and short side of portfolio management.
DISCLAIMER: Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any fund, manager, or program mentioned here or elsewhere.