In an Uncertain Macro Environment, Investors Should Focus on Cheap, Straightforward Companies

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Includes: DIA, HBI, QQQ, SPY, TPX
by: Amit Chokshi, CFA

The Real Goldilocks?

From 2005-2007, financial media became enamored with the term "Goldilocks" when describing the US economy. The term was used to suggest that the economy was neither "too hot" nor "too cold" -- instead "just right" and providing a sound foundation for economic growth with benign inflation. With the benefit of hindsight, investors realize that this was not the case resulting in a pretty big shift in risk appetite.

Since the fallout of 2008, investors have preferred to focus on chasing yield, hoping to earn returns superior to essentially no returns with money market funds but do not want to take on principal risk. This is seen in fund flows data as bond funds hit an all time record in 2009 with $396B in inflows according to Strategic Insight. Prior to 2009, inflows in either stock or bond mutual funds never exceeded $300B. More importantly, in 2009 stock fund flows were only $30B (excluding emerging markets) with inflows for US equity funds of just $6B1. Investor apathy for US equity funds has continued in 2010 with Morningstar reporting that over the trailing twelve months through February 2010, $21.3B has exited the asset class with February 2010 reporting $3.7B in outflows2. In contrast, bond funds continue to experience healthy inflows which makes sense from a psychological perspective.

Investors were run over in 2007 and 2008 and despite a rebound in 2009, key benchmarks such as the S&P500 are still down relative to even January 2007. In fact, over the past decade, current levels of the S&P500 are just really above the 2002-2004 period. With two recessions and challenging bear markets to bookend the past decade, investors may generally be fed up with equities and prefer to chase yield with safe bond funds. With past history and a constant news stream perpetuating uncertainty and fear, it's not surprising that investors are spurning equities so strongly. However, the high skew of inflows towards bond flows along with the potential for some upside economic surprises may provide an a real goldilocks scenario for investing in equities. Investor participation in equities has dropped considerably with bond inflows at record highs and equity inflows at historical lows. In isolation this may not be a huge signal but demonstrates investor fears. For example, one of my investors has been working to get more clarity on a struggling investment in Dubai. This investor has made investments in alternative asset classes and projects typically catered to high net worth individuals over the years and some have struggled. Due to the hurdles these investments can face, he recently started purchasing Ginnie Mae bonds, virtually a 180 degree turn from his prior investments. Of more importance was a recent conversation where he mentioned that he was discussing his Dubai investment with a fellow investor based in Europe. He found that both he and this other wealthy investor were putting money into bonds and humorously suggested that if he and others were pouring into bonds, that might not be the place to be. Aside from anecdotal investment sentiment, investors may be missing some potential good news in the job market.

Economists are forecasting jobs growth of 1500,000-400,000 for March 2010. This is due to a February jobs report of a loss of 37,000 jobs which was better than expected and also included particularly challenging weather in parts of the country. While there will be roughly 100,000 jobs due to hiring related to the Census, net job additions would be a huge turnaround for an economy that has been shedding jobs for such a long period of time.

As bad as things are, we are very likely close to the peak of unemployment figures. Consider the Employment Population Ratio which nosedived from 64% in 2001 to 62% in 2003. This ratio bounced from 62% to slightly higher than 63% during the peak of the housing bubble but now hovers around 58%, levels last seen in the early 1980s. While I believe we're in for a sluggish recovery, this is the consensus view. Monthly job additions of 100,000-150,000 should help reduce unemployment but these projections ignore the potential for upside surprises. And most observers are waiting for reports to come in badly to impose a market reversal. This is a tough fight to wage when unemployment is 10% to 17% depending on which unemployment category is being used, and when the Employment Population Ratio is near multi-decade lows.

Inflation is also tame. While there are some that favor a hyperinflation argument, the data suggests we are facing deflation. Those that cite hyperinflation ignore what occurred with Japan. Shorting Japanese government bonds in the early 1990s was the "slam dunk" trade that some think shorting US Treasuries now will be. Since that time period yields on Japanese bonds have continued to grind lower despite high levels of debt and stimulus efforts. The same could very well occur in the US with Treasury yields confounding those that highlight high debt levels and government spending as inflationary drivers.

So we have investor sentiment that is largely ignoring US equities with many retail investors aggressively adding to bond funds, views towards the economy allowing little room for upside surprises, and benign inflation. These seem to suggest increased allocation to stocks. The one "caution" sign is that stocks in aggregate are not a screaming bargain.

However, given the skepticism regarding the economic recovery, it is possible that analyst estimates for 2010 and 2011 may be a bit tepid. Given the massive costs stripped out of many corporations over the past year, small improvements in the top line can yield outsized earnings improvements. As a result, if the economic recovery takes some by surprise, earnings growth could outpace current estimates. With 2010 S&P500 estimates of roughly $78 per share, the index is valued at just 15.0x these estimates. However, 2009 was driven by actual results that beat estimates and if this trend continues in 2010, the S&P500 could rally much more than people expect.

The main "problem" for the bear case for the broader market is that most problems are known. Everyone is talking about unemployment, bank capitalization, sovereign debt risk, commercial real estate, and residential real estate. These are broader, macro issues that become very challenging to construct an investment approach around, especially when these problems are front page news.

Sleep on it...

Rather than focus on macro factors that are all too often difficult to discern in terms of market impact, investors should focus on individual opportunities. One reason is because individual companies generally have just a handful of catalysts and "triggers" that investors need to keep track of. In contrast, macro investing requires following far more inputs and the weight of those factors can change on a daily basis. What may be a critical focal point one week may be a non-factor in the following week which can trip up investors that attempt to build a portfolio based broadly on macro items such as sovereign debt crises. Rather than focus on these aspects that are far too difficult to quantify, investors should focus on individual companies that are cheap and easy to understand. Against that backdrop, investors may wish to consider Sealy Corporation (ZZ) as a potential investment.

ZZ is a leading mattress maker, commanding 19% of the $6.2B US mattress industry. ZZ has been the top selling brand in the US for over 20 years while also commanding top honors in Canada and Mexico. While a number of companies in 2010 are still facing the prospect of declining sales growth, ZZ is poised to experience top line sales growth in the single digits. This is a business that has typically had gross margins in excess of 40% and EBITDA margins of 12%. These margins took a hit in 2008 before recovering in 2009, in part due to management's cost initiatives. ZZ management has been accustomed to running a tight ship as ZZ was a portfolio company of buyout shop KKR before going public in 2006 and as a result was able to defray corporate costs and preserve operating margins. In 2010, ZZ should be poised to rebound smartly with potential EBITDA margins of 14-15% and gross margins of 41%.

The biggest criticism for ZZ is its balance sheet and high debt levels. ZZ has about $716MM in net debt but this is against $164MM in EBITDA so total debt is just about 4.4x Net Debt/LTM EBITDA. This is a high level of debt but not uncommon for consumer companies that generally offer staple products. For example, Hanesbrands (NYSE:HBI) carries a significant debt load but given the steady demand nature of underwear and staple apparel and its strong cash flow capabilities, HBI can handle a high debt load. HBI rallied from the mid single digits last year to over $20 as investors realized that HBI was not in danger of going out of business.

ZZ offers similar dynamics to HBI. In the case of mattresses, replacement demand is 67% of revenues which suggests there is considerable pent up demand and ZZ can experience top line growth in the high single digits in 2010, which would yield near $1.4B in revenues. Assuming improved margins from 2009 based on cost initiatives taken by management, ZZ could generate $213MM in EBITDA. Interest expense will total about $79MM but cash interest expense is just $64MM as the difference is non-cash accretion related to pay in kind notes ZZ issued in 2009. Capital expenditures ("capex") typically run 2% of revenues although ZZ has brought this down to 1% so capex could range from $14-$28MM. On a cash flow basis, ZZ could generate over $100MM in free cash flow (including full cash taxes).

The cash flow production of ZZ makes ZZ's debt less of a concern. In addition, ZZ faces no significant refinancing risk as most of its debt matures from 2013-2014 with the bulk due in 2016. ZZ has also been repurchasing its debt with excess cash flow, allowing for additional deleveraging. So once investors are comfortable that ZZ's debt load is easily serviceable, the next question is valuation and ZZ is cheap. The sellside community appears to be a bit reserved on ZZ, overlooking some company and industry specific factors that should benefit ZZ.

One benefit to ZZ is that one of its competitors, Simmons, filed for bankruptcy recently. During the bankruptcy process, Simmons merged with another competitor, Serta, combining the #2 and #3 players in the industry. This merger will strip out excess capacity and strengthen pricing power across the mattress industry. Another area of growth is in the premium mattress segment with mattresses priced over $1,000 experiencing the most growth. This tends to be memory foam and viscoelastic mattresses and ZZ has been increasing its offerings in this segment. With this backdrop, ZZ is capable of generating $0.20 in EPS in 2010 and $0.35 in EPS in 2011. Based on peers which trade at roughly 15.0x 2011 EPS, ZZ could be worth over $5 per share or roughly 30% higher where it currently trades.

On an EV/EBITDA basis, ZZ could be worth in the high $4-$5 per share range. Rather than get caught up in the market and economic noise, ZZ may offer investors the chance to invest in a boring company that can generate some impressive returns.

Disclosure: Author manages a hedge fund and managed accounts long ZZ.

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