The Sky is Not Falling…Yet
Were stocks over valued? Yes, on the whole equity prices got ahead of where they should have been earlier in the year and a correction was warranted. But the economy is not falling apart just yet and we are not heading into a recession next quarter. So far, the S&P 500 (SPY) has fallen 20.2% from its intraday peak of 293.94 in September. The rate of decline since September has been brutal. For calendar year 2018, SPY has fallen 12.2%. Of course, neither of those numbers includes dividends which would reduce the carnage very little.
Throughout history market corrections (drops of 10% but less than 20%) happen on average once per year (about once every 357 days according to Deutsche Bank). The average correction knocks 13.3% off stock prices. This one has turned into a bear market (by strict definition; using closing prices SPY has dropped 20.1%) and has been painful than the average year. But there are a few reasons for optimism within this period of gloom.
The economy is still growing strongly, albeit slowing from the torrid pace of 4.1% during quarter two of this year. But there are reasons to expect good things to happen in the not-too-distant future.
The National Retail Foundation is expecting one of the best holiday shopping seasons in recent memory with retail sales forecasted to increase by between 4.3% and 4.8%. Let’s not forget that consumers make up about two thirds of the economy so when we are spending the economy is growing. And when we are spending at a higher than usual rate then the economy should be growing even faster than usual. Going into this holiday week the Consumer Sentiment report from the University of Michigan came in at a strong level of 98.3 (up 0.8 from November and above expectations). The current economic conditions reading was 116.1, one of the strongest in a year. Of course, those readings could fall when (if) folks open their quarterly brokerage account statements in January. In 2017, the stock market hardly paused all year dipping only slightly. We never experienced a correction last year so it is only natural that stocks needed to consolidate those gains and take a breather this year. The market cannot go straight up forever. The current market pull back may be just making up for over exuberance in 2017. As negotiations with China progress (I hope that is the right choice of words) there should be additional significant purchases by China of U.S. produced goods to help reduce the trade imbalance. China made a purchase of 1.5 million tons of soybeans this past week, the first since the trade war between the two began. As part of the trade truce agreed to by Presidents Trump and Xi last week, China agreed to purchase a significant amount of U.S. goods over the 90-day period of extended negotiations. Such major purchases can’t hurt the economy in the short run. And if a settlement can be reached by the end of the first quarter of 2019, the markets could rebound nicely.
Of course, you can find articles that call the initial soybean purchase “just a drop in the bucket” but it is, nevertheless, a big drop and just the first of two already agreed upon by the two sides. Those two purchases will amount to about 10% of all soybean exports from the U.S. to everywhere for a year.
On the other side of the coin, this could be the beginning of a much larger fall in stock prices. There is no denying that possibility. Trade negotiations are in play but there is nothing definitive yet, so I expect that the downside from trade issues is limited until something new breaks into the headlines. The government shutdown is being played as a death knell but we should all know by now that the government will only shut down non-essential operations like national parks. Social Security and other welfare checks and transfers will not get delayed. Treasury is not likely to miss making any interest payments. The impact on the economy should be minimal but the media will claim it’s the end of the world. So, what other events are coming that could bring down the economy? Black swans, maybe, but nothing about which we already know. So, one could argue that the worst case known scenario is already baked into the market.
Even if that is not the case, it may be time to consider adding a little of this and a little of that (starter positions) and averaging down if the market does, in fact, go lower. This is the time to look for bargains on the quality stocks with strong future growth potential. Why pay full price?
Why sell stuff when it goes on sale? Shouldn’t we be buying?
This is something I have never been able to understand. When cars go on sale more people buy cars. When a clothing store announces 30% off everything people flock to the stores and buy like crazy. When stocks go down those same people sell at rock bottom prices. This is nuts! It is the exact opposite of what we should be doing.
I realize that people fear the worst when things turn painful; it is human nature to run away rather than endure more pain. I think that’s called self preservation. But investing is for a lifetime not just this next month or year. The market goes up and down. Buy low and sell high. So, why do people do the opposite and buy when stocks are highly priced then sell after a market correction, or worse after a crash? I just don’t understand it and all I can say is: Thank you!
Because I love sales, especially when I am buying something that I have always wanted to own like shares of a great company with excellent future growth prospects and a rising dividend. So, the reaction of the lemmings in the market has always escaped my understanding. Now, trying to catch the exact bottom is a fool’s game so I just try to buy the stocks of companies I want to own for the long term whenever those share prices have fallen to what I consider to be a bargain (or 33% below my estimated intrinsic value).
Building a Retirement the Right Way
Or, at least, the way I think is right. I aim to add streams of future income, layer upon layer, over time. But I only like to own companies of the highest quality. That is why I focus on companies that consistently produce superior results, year after year. Of course I also like companies that are likely to continue to do well in the future, those with a sustainable competitive advantage or the proven ability to adapt to the changing business environment.
One of the companies I have my eye on is Seagate Technology (STX), the world’s largest manufacturer of hard disk drives for digital storage of information. The company is in a cyclical industry and, thus, it behooves investors to wait for the stock to tumble in order to capture good value. The dividend is currently $0.63 per quarter which represents a 7.9% annual compounded rate of increase over the past five years. STX does not raise the dividend every year but when it does increase the dividend the increase is usually a healthy boost. Current yield is 6.9% and well covered. Ten years ago the dividend was $0.12 per quarter, for perspective, which represents an increase of 425%, or and increase of over 18% compounded annually. While I don’t expect that pace again any time soon, I think the average of 7% or 8% a year will suit my needs and is much more sustainable.
I should take a moment to caution dividend investors about Seagate’s dividend history. In the last down cycle (2016) the company held the dividend steady, but there have been times, like during the financial crisis of 2008-09 when the company skipped paying the dividend for a few quarters to conserve cash for operations. I don’t like that either, but since the company has improved its cash flow in recent years I expect that a flat dividend to be more likely than a temporary elimination. But, if things get really bad, anything is possible so be forewarned. The key is that the company has been able to weather each storm in the past and come back more strongly each time. And each time the dividend eventually rises with the average compounded increase being very tempting.
Now let’s look at the numbers and see what our algorithm tells us about Seagate.
Main Street vs. Wall Street
In analyzing Seagate Technology, we will present some unique ratios that our Friedrich Investing System uses along with a real-time quantitative analysis that will demonstrate the power of free cash flow in the investment process. In doing so, we will also show readers how to analyze one's own portfolio holdings on Main Street vs. Wall Street.
Main Street is where Seagate Technology operates and Wall Street is where its shares trade. The Seagate Technology shares that one can purchase on Wall Street are in the public domain, and the company has little control over how each share will trade. Seagate Technology is required to release its earnings report each quarter and, from time to time, it also provides press releases with updates on how its operations are doing on Main Street.
Main Street is where Seagate Technology invests in its own operations and sells to its customers. How well the CEO of Seagate Technology and its management do in selling those products determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer (or even just a smart phone), an internet connection, and a brokerage account can buy or sell any stock at any time, expertise is not a requirement in order to invest on Wall Street.
The result is that Wall Street can be a very dangerous place for retail investors who tend to invest through emotion or follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic. Thus, we have the classic case of "greed vs. panic" and the irrational behavior I alluded to earlier.
Creation of the Friedrich Algorithm
Having noticed this problem some 30 years ago, Mycroft spent the last three decades building an algorithm called Friedrich. His algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, Mutual Fund, or individual portfolio with the use of our Portfolio Analyzer. We recently did so when we compared Apple ( AAPL) to the S&P 500 Index ( SPY) Apple Vs. The S&P 500: Which Is The Better Investment?
Many years ago, while reading Berkshire Hathaway's ( BRK.A) ( BRK.B) 1986 letter to shareholders, he discovered a ratio, which Mr. Buffett entitled "Owner Earnings," or what we may consider to be Mr. Buffett's version of "Free Cash Flow." Amazingly, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.
"[Owner earnings] represent [A] reported earnings plus [B] depreciation, depletion, amortization, and certain other non-cash charges… less [C] the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."
We have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. We know this as Mycroft was able to calculate the FCF ratio using old Value Line's sheets for his 60-year backtest of the DJIA from 1950 to 2009.
In the backtest mentioned above, Mycroft demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price to Free Cash Flow Ratio that the probability of success will dramatically increase in most cases. He has renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio is calculated.
Wall Street Analysis
Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor / [(net income per share + depreciation per share) - (capital spending per diluted share)]
Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))
The above are the ratios we use when analyzing a stock on Wall Street, and below are the ratios we use when analyzing a stock on Main Street.
Main Street Analysis
FROIC means "Free Cash Flow Return on Invested Capital"
Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]
FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)
What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it, therefore, has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street that this news will eventually show up on Wall Street's radar.
Before we get into the analysis of Main Street versus Wall Street for STX we first need to explain our treatment of debt and how we adjust for excessive use of leverage.
Sherlock Debt Divisor
A major concern that we have these days in analyzing companies is the amount of debt taken on relative to operations and whether management is abusing this situation by accumulating more debt than it requires. Debt, when used wisely, allows for what is called leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what we have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.
What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do we do this? Well, we start with a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, we reward it and punish those whose long-term debt exceeds its working capital. So, if this resulting Sherlock Debt Divisor is higher than the current stock market price, then leverage is being used and the more leveraged a company is, the worse the results of this ratio will be and, subsequently, the less attractive its stock will be as an investment.
Thus, having successfully explained our use of the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for Seagate Technology. TTM (trailing 12 months) is as close to real-time data as we can get without adding assumptions and based on when each company reports.
Market Price Per Share = $36.13
Working Capital = Total Current Assets - Total Current Liabilities
Total Current Assets = $4,520,000,000
Total Current Liabilities = $3,170,000,000
Working Capital = $1,350,000,000
Long-Term Debt = $4,320,000,000
Diluted Shares Outstanding = 292,000,000 (decreased by 7 million shares since 2017)
Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/(Diluted Shares Outstanding))
Sherlock Debt Divisor = $36.13 - (($1,350,000,000 - $4,320,000,000)/ 292,000,000))
Sherlock Debt Divisor = $46.30
Since Seagate Technology has more Long-Term Debt than Working Capital, we, therefore, must punish it and use the new $46.30 price as our new numerator in all our calculations.
Wall Street Analysis of STX
Price to Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/[(net income per share + depreciation per share) - (capital spending per diluted share)]
Sherlock Debt Divisor = $46.30
Net Income per diluted share = $1,450,000,000/292,000,000 = $4.96
Depreciation per diluted share = $571,000,000/292,000,000 = $1.95
Capital Spending per diluted share = $419,000,000/292,000,000 = $1.43
$4.96 + $1.95 -1.43 = $5.48
Price to Bernhard Buffett Free Cash Flow Ratio = $46.30/$5.48 = 8.45
Now, if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result), you will notice that our result of 8.45 is considered excellent.
We last ran our data file for Seagate Technology on December 24, 2018, and our Friedrich Algorithm gave a recommendation to our subscribers that Seagate Technology is a "Buy" as our Friedrich Data File and Chart below show. There you will also find the last ten years of Seagate Technology's Price to Bernhard Buffett Free Cash Flow results.
Source: Ask Friedrich
Main Street Analysis of STX
Now that we have shown everyone how we calculate our Price to Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio. FROIC means "Free Cash Flow Return on Invested Capital.”
This is how we calculate it:
Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]
FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)
Net Income per diluted share = $1,450,000,000/292,000,000 = $4.96
Depreciation per diluted share = $571,000,000/292,000,0001 = $1.95
Capital Spending per diluted share = $419,000,000 /292,000,000 = $1.43
Revenue Growth Rate TTM = 3.2%
[(($4.96 + $1.95) (103.2%)) - ($1.43) = $5.70
Long-Term Debt = $4,320,000,000
Shareholders Equity = $1,850,000,000
Diluted Shares Outstanding = 292,000,000
FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)
$5.70/$21.13 = 27%
FROIC = 27%
What To Do?
Now, if one goes to my FRIEDRICH LEGEND again (on what is considered a good or bad result), you will notice that our result of 27% is an excellent result and tells us that on Main Street Seagate Technology generates $25 in forward free cash flow for every $100 it invests in total capital employed.
Seagate is doing excellent on Main Street and priced at a bargain on Wall Street. Now, if one can build a portfolio concentrating on stocks that are performing this well on Main Street while also at attractive Prices to Bernhard Buffett FCF ratios, you should expect your portfolio to be a star on both Main Street and Wall Street. Finding companies that have excellent results on Main Street and Wall Street (simultaneously) these days is, unfortunately, like trying to find a needle in a haystack.
Finding one that also pays a hefty dividend of almost 7% is even better! The payout ratio is about 51% and the stock sports a P/E (price to earnings) ratio of 7.3 (TTM) and 6.92 (Forward based upon consensus).
To be sure, excess inventory in the supply chain could hurt revenue and earnings in the next quarter or two and we suspect that expectation is built into the current price. But beyond that the future continues to look bright for Seagate. We consider this to be a bargain but if stocks in general continue lower it could get even cheaper. So, the plan should be to add a portion of what would be a full position soon and then add more if the price drops further at intervals of maybe $3/share (or about 10% from current price). Eventually this market will turn back up and Seagate has a lot of room to grow its multiple back into at least the low double digits.
Caution: it may require patience.
In conclusion, it is our belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor toolbox in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below.
At Friedrich Global Research, we stick to the numbers. We do analysis like what you saw in this article, but for 20,000 stocks from 36 counties around the world. We also provide model portfolios ranging from ultra conservative to aggressive growth, so you can apply our research to your investing easily.
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Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.