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2001 - 2013 Deputy CIO, Julius Baer Investment Management/Artio Global Investors 2001 - 2007 Co-Head Global Equities, Julius Baer Investment Management/Artio Global Investors 1999 - 2007 Head of US Equities, Julius Baer Investment Management/Artio Global Investors 1997 - 1999 Senior Investment... More
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  • It's The Great Rotation Charlie Brown

    In the 1966 animated movie, "It's the Great Pumpkin, Charlie Brown", Linus van Pelt sits in the pumpkin patch on Halloween evening, waiting for the Great Pumpkin to arrive while his friends trick or treat from door to door gathering candy and popcorn balls. Unfortunately, for Linus, the Great Pumpkin never shows.

    Today, there's lots of talk about "The Great Rotation" - an idea that as the economy recovers, rates will rise, investors will abandon bonds and equities will soar based on a better economy and better earnings. Like Linus, investors who believe in this real world coming, will be disappointed.

    Over the past year, the S&P 500 is up by more than 20% while earnings per share have climbed only 4.2% (even less excluding financial stocks). Thus, investors have already been factoring in improvement into their willingness to pay more for each dollar's worth of today's earnings.

    The flaw in their thinking is twofold:

    • First, stocks tend to do better when rates are falling, than when they are rising
    • Secondly, there are two "components" to earnings - operating and financing, and rising rates will dramatically challenge the second of these

    When we think of how a company works, we assume without much afterthought, that it does better when the economy does better. However, let's examine this a little bit more.

    A company makes its widgets, or provides a service, which they sell for a certain amount. However, there was a cost to manufacturing and selling that widget or service - materials, electricity, labor, marketing, etc. The difference between these costs and the sales price is the operating profit - or what we think of as "the business".

    There is, however, a second, less considered component to earnings, and that is the financial component. In order to make their widgets, the company had to invest in plant, property and equipment. Usually, they will have to sell equity or borrow money to fund this investment. Whether they choose to issue equity or bonds, borrow from the bank, set the term of the borrowing, etc. is a financial decision every bit as important as the decisions made in manufacturing its product.

    Over the past few years, many companies reacted to the Fed's decision to artificially lower interest rates (Quantitative Easing) by borrowing to fund their investments. As evidence of this, we can see how debt outstanding as a percentage of assets has risen since QE was introduced in 2008.

    (click to enlarge)

    Even when accounting for the cash that has built up on balance sheets (borrowing for future purposes), leverage has still increased. This is most clearly see if we subtract cash retained on the balance sheet from the total debt amount (giving us Net Debt) and express that as a percent of assets. Such an exercise shows a rise in leverage over recent years to 14.2% of assets (from a 15-year average of 11.5% and a 2008, pre-QE low of 7.1%)

    (click to enlarge)

    Interestingly, however, the overall cost of this borrowing has not grown, even as the amount borrowed has. At the end of 2012, interest expense fell to 1.78% of sales from a 15-year average of 3.88% (and note it had never been below even 3% of sales until 2009).

    (click to enlarge)

    So let's say a company sells it widget for $100, and its cost of materials, labor, etc was $90. Then their operating, or business, margin is 10 cents on the dollar. Now, let's subtract the costs of borrowing, currently 1.78 cents. So the bottom line profits are 8.2 cents for every dollar of goods sold. If, however, the cost of borrowing were closer to "normal" (3.88% of sales), the bottom line would be more like 6.1 cents. In other words, you could expect earnings to fall roughly 25% even though the "business" environment hasn't changed at all.

    Yet another aspect of financial management relating to the low rate environment engendered by QE is the option many companies have followed to borrow at low interest rates for the purpose of buying back stock. Remember, there are two ways to grow EPS, grow the earnings or shrink the number of shares. Buoyed by QE, companies have opted to buy back shares, allowing EPS to grow faster than earnings overall (in some instances, outright earnings declines have been "converted" into EPS gains through a shrinkage of the share base).

    For the market as a whole (the S&P 500 index), In each of the past five years, operating income per share, has grown faster than overall operating income - evidence of a share base shrinkage (A positive numbers in the chart below indicate share buy backs. A negative number, share issuance). As rates rise, this practice of borrowing to repurchase shares will diminish and the ability to manufacture EPS growth will be further challenged.

    (click to enlarge)

    Prima facie evidence that such financial machinations are still alive and well, surfaced earlier this week when Carl Icahn tweeted about acquiring a large stake in Apple Computer. Icahn stated that Apple didn't even need to grow its business for its share price to climb from $525 to $625 per share - they could simply borrow money at 3% and buyback shares that were more dear. So whilst this financial maneuver is still viable, investors will be pressed to continue it should the cost of borrowing climb.

    In simple terms, any rise in interest rates will bring an end to the ability companies have had to manage the financial component of their businesses, even as the economy improves and helps their operating business.

    There is one final element to managing the "financial" component of earnings that has nothing to do with interest rates. It has to do with taxes. As tax rates have come down over the years and as US companies do more business in lower tax jurisdictions, the effective taxes they have paid have fallen. In other words, they get to keep more of the money they earned - another boost to the "non-business" side of earnings.

    Looked at from an economy-wide perspective (using the National Income and Product Account data from the US Bureau of Economic Analysis), the effective tax rate paid by US companies has fallen dramatically, especially in the past decade. For the most recent 12 months, companies have paid out a little more than 18% of their earnings as taxes. That's down from a 50-year average of roughly 34% - a reduction of almost 50%. To put this into some perspective. If today's effective tax rate of 18% were to return to the 25% rate which was the norm as recently as 2002 - 2006, the net margin would decline from 8.1% to 7.4% - corresponding to an earnings decline of just over 8.5%.

    (click to enlarge)

    Unlike interest expense and share buybacks, I don't necessarily think this is a trend that is going to reverse soon, but by the same token, I don't see much room for improvement, especially as debt-laden Governments, worldwide, look to increase their revenue base.

    So Linus and equity bulls, whilst I admire your faith and convictions, evidence would seem to be against the arrival of The Great Rotation.

    Sep 04 2:28 PM | Link | Comment!
  • The Illusion Of S&P 500 Profit Margins

    The Profitability Illusion

    The current near-record level profit margins of the S&P 500 are largely an illusion, created solely by the fact that interest costs have fallen precipitously, even as overall debt levels have increased. Operating profitability, is actually below average. As the Fed's Quantitative Easing program is unwound, earnings are at significant risk.

    Current profit margins for S&P 500 companies remain near historic highs even as the broader economy struggles and real income growth remains anemic. The stock market trades near record levels supported, if not by fundamentals, by promises of the Fed to hold interest rates near historic lows. Today though, the certainty of those promises is being discussed with potentially very negative consequences for US and Foreign Markets.

    Market bulls point to high profitability and supportive market action as well as benign valuation as reason for their continued positive stance. Indeed, market participants are by many measures, as bullish as ever (hedge fund net longs, bullish sentiment).

    However, analysts, like myself, who believe that margins tend to be cyclical in nature, caution that today's high margins are a reason for restraint, not celebration. Traditional valuation metrics like P/E ratios, tend to understate the valuation of markets when margins are well above average, as they are today, leaving open to question whether the factors supporting the market are capable of remaining in place for an extended period.

    (click to enlarge)

    Source: Brett Gallagher, Zack's Investment Research

    Bulls will counter that we have witnessed a permanent shift upward in margins given the now global nature of production and the ability of corporations to manage costs better than ever by using offshore operations when beneficial. This same argument is often cited when explaining why US personal income growth remains anemic. While on the surface this is a believable narrative, the data does not back it up.

    When margins are decomposed into their component parts:

    • operational factors (sales less the direct costs of production)
    • tax factors (the percentage of sales one forfeits in taxes)
    • financing factors (amounts paid due to corporate financing decisions), and
    • extra-ordinary items (one-off items, not likely to be recurring in nature)

    it becomes obvious that the historic profitability of the S&P500 today relies solely on the fact that interest costs have fallen precipitously during the Fed's period of QE even as overall debt levels have increased.

    Current net margins are quite high by historical standards (8.04% versus the 15-year average 6.55%). However, "operational margins" (the profitability of a company apart from their taxes and financing decisions) are now actually below average - so much for the benefits of global production. The reason for the discrepancy between margins as generally discussed and operational factors has to do with the very low level of interest expense (1.78% of S&P 500 sales compared to an average of 3.88%), even though overall leverage (debt as % assets) has risen to 14.2% from the long-term average of 11.5% (Averages use year-end figures calculated from Dec 1998 through Dec 2012).

    The charts which follow demonstrate this dynamic quite clearly. After a bump during the period 2005 - 2007, interest expenses have fallen dramatically in spite of the fact that debt levels climbed (most precipitously in 2009). I have chosen to show both total debt as well as net debt measures. It is my belief that net debt better hints at corporate vulnerability to leverage as it takes into account "tactical" debt issuance where retained cash can, theoretically, be used to immediately reduce leverage should borrowing costs reverse).

    (click to enlarge)

    Source: Brett Gallagher, Zack's Investment Research

    (click to enlarge)

    Source: Brett Gallagher, Zack's Investment Research

    (click to enlarge)

    Source: Brett Gallagher, Zack's Investment Research

    The chart below shows "operational margin" levels since 1998. Current readings are slightly below average. Should interest costs rise and encroach on overall business profitability, it is net margins that will have to suffer disproportionately.

    (click to enlarge)

    Source: Brett Gallagher, Zack's Investment Research

    Two conclusions can be drawn from the above. First, given today's low level of interest rates, further progress in margin enhancement via lowering interest expense without paying down debt would seem limited and operational metrics must improve if current margins are to be sustained.

    Secondly, should rates reverse their downward trend, interest costs could have the opposite effect on profitability as they rise dramatically. If interest expenses revert to their historic average, net margins would fall below 6% (all else equal, this results in a 25% earnings decline from today's levels)

    IN CONCLUSION, assuming continued sluggishness in economic (and, hence sales) growth, high levels of leverage and a bottoming of interest rates, maintaining margins above the norm is unlikely and reversion to mean becomes a more likely outcome than a secularly higher level of profitability. In such an environment, earnings are vulnerable as are P/E multiples, meaning equities themselves are at risk.

    In the next posting to this blog, I will provide long-term return assumptions for US, UK, Continental European and Japanese equities (under a range of margin and P/E assumptions) as well as a variety of government and corporate bond markets using a proven valuation methodology. The results will have significant, if uncomfortable, implications for plan sponsors and other investors.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: Brett Gallagher is formerly the Deputy Chief Investment Officer at Artio Global Investors and is currently an independent market analyst.

    Jun 24 3:23 PM | Link | Comment!
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