June 2014

………………Thoughts and Comments

Q1 Earnings are Less Than Impressive

Q1 earnings are virtually complete: there are a few technology companies still to report, but some 95+% of the S&P 500 have reported.  Results were generally lackluster.  To summarize our findings, revenue and net income growth are low but positive and margins continue to be quite high, but debt levels are rising and P/Es are high as well.  Future growth in the stock market will have to come from revenue and earnings growth, not by P/E expansion. Read on for the details.

In general, revenues were up about 5% year over year, in line with the last several quarters, while net income growth continues to slow. The numbers are not terrible, but mid-single digits on average are well below growth rates in 2010 and 2011, while stock multiples are much higher now than they were then. EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is growing mostly because it excludes interest expense, which has grown significantly in the past twelve months (see charts 1&2).

…………………………………………Chart 1 (data supplied by S&P Capital IQ)


Corporate debt has been rising since the third quarter of 2011, and interest expense has been rising since the second quarter of 2012.  The argument that companies are in better fiscal shape than at any time since 2007 is simply not true.  While debt/total capital is not at all-time highs, there is no question that companies have been taking on debt (see chart 2).

……………………………………..….Chart 2 (data supplied by S&P Capital IQ)


Growth rates of net income has been declining, as we said, yet earnings per share are rising.  This means that there must be fewer shares outstanding and that is confirmed by the negative share count growth rate (meaning the number of outstanding shares is falling).

………………………………………….Chart 3 (data supplied by S&P Capital IQ)


So we have revenues growth rates flat-to-slightly-rising, net income growth rates slowing, and debt levels and interest expense levels growing at faster rates than either revenues or net income.

Why would companies increase their debt levels?  They might do it for several reasons: 1) to grow the company by updated and/or adding new equipment, hiring more employees, creating new products and/or services and/or by building new facilities; 2) to make an acquisition; 3) to pay a dividend; or 4) to buy back stock.  The first two reasons certainly can lead to revenue and net income growth, the last two certainly do not.

But as the next chart shows, the primary use of debt has been to buy back stock, and this is disconcerting.

The problem is that buying back stock is a manipulation – it adds no value to the company.  The only time a manager should buy back company stock is if they believe that their stock is so cheap that the company will make more money by purchasing shares than they can by investing it in their business, and this should be a rare occurrence, not a long-term strategy.  If P/E ratios are high, or even above average, then the company is overpaying for its own stock.  More importantly, the money is going to things that do not help the company grow.

Some capital has gone towards mergers/acquisitions, as has been seen by Facebook’s recent $19 billion and Apple’s $3 billion acquisition announcements.  History, however, shows that most mergers and acquisitions do not work.  Few efficiencies are gained, and often times the acquired company pays far too much.  Again, with above-average P/Es, many acquisitions are looking expensive – and in many cases, the companies purchased have no profits.

………………………………………….Chart 4 (data supplied by S&P Capital IQ)


Notice in chart 5 we reach the same conclusion looking at different uses of capital as a percentage of revenues rather than just the number of companies spending more on the different capital uses. Again, both capex and cash from operations are declining as percentage of revenues while share buybacks are increasing – rapidly.  Again, we see that in general, companies are achieving higher EPS growth by reducing share counts rather than investing their business.

……………………………………..Chart 5 (data supplied by S&P Capital IQ)


Margins are off a little in the latest quarter, but in general have been rising for several years now.  It would be quite surprising for margins to rise much from here due to numerous headwinds that are starting to appear.  These headwinds include higher commodity costs, new healthcare expenses, government regulations and attempts at new regulations are being proposed and pushed all the time.  Finally, at some point, wages should start to rise as well.

An example of rising costs can be seen in McDonald’s latest earnings call, where they announced a 3%-4% price increase in the U.S. and Europe due to higher prices for beef.  At the same time, there is pressure to raise the minimum wage, which is likely to have an impact on many restaurants.

Now this is not necessarily bad news if an expansion and jobs and wages leads to increased consumer spending.  However, that could add to inflationary pressures at a time when the Feds around the world are printing unprecedented levels of cheap cash.

However, given the risks to company margins, most stocks appear to be at very full valuations, which makes it hard to justify increasing exposure given the risk vs. reward.

…………………………………………..Chart 6 (data supplied by S&P Capital IQ)


………………………………………….Chart 7 (data supplied by S&P Capital IQ)


………………………………………….Chart 8 (data supplied by S&P Capital IQ)


To pull this together even more succinctly, let’s use Apple as an example.  Long a dynamic, creative company that was (and is) a money machine, the company deserved a premium valuation.  However, with the passing of Mr. Jobs, the company has become far less creative and much more of a me-too producer rather than a leader.  The following simple study graphically shows changes that leave us questioning the company’s current valuation.

Let’s start by looking at their income statement over the past five years.  The graphs below show the growth rate of their revenues, EBITDA and net income since the end of 2009.  Notice that for the past year, all three growth rates have slowed substantially, while margins have been falling.

………………Apple – Income Data drops to negative growth rates  (data supplied by S&P Capital IQ)


…………….…..Apple – Margins over the past ten years (data supplied by S&P Capital IQ)


When we look at the growth of Apple’s EPS over the past eleven years versus the shares outstanding, it is amazing that for years the share count rose while EPS grew.  However, in the past twelve months, earnings have stalled and the company has been lagging many of the new innovations in communications.  Concurrent with this shift is the sudden and rapid drop in their share count.

During the latest earning report, Apple announced they were going to increase the amount of the share buybacks by 50% and split the stock.  Last year, Apple raised a record $17 billion to largely buy back $60 BILLION in stock.  This year, they have raised another $12 billion and increased the share buyback to $90 BILLION, all while they have over $10 billion of cash on the books. Yet, during this same period, the amount of money they spend on capex (the money that goes to the creation of products and services, which is where revenues come from), has dropped from almost $10 billion to about $7 billion, a 30% drop.  At the same time, Apple stock is priced at a significant premium to its competitors based on P/E.  This is not to say that Apple doesn’t have positive aspects, but these points certainly ought to give pause to investors.

……….……..Apple long term eps growth and share count (data supplied by S&P Capital IQ)


………….Apple – Cash from Operations vs Capex  – Comparison (data supplied by S&P Capital IQ)


……….………Apple – P-E Ration over the past 5 years  (data supplied by S&P Capital IQ)


The Latest Rotation – Zig When They Zag

The chart below compares the dividend yield of the S&P 500 to the yield on the ten-year U.S. treasury.  As long as companies are growing and this is reflected in stock prices, then investors tend to be less concerned with lower dividend yields.  However, if we aren’t getting the growth in earnings and stock prices, stock prices will become more susceptible to price adjustments to earn higher yields.

………………………………………………(data supplied by S&P Capital IQ)


We believe this has already started to happen.  In the past several months, the momentum stocks have faltered while the big cap dividend plays, led by the utilities, have become the latest “hot” sector in which to rotate.  Where the Russell 2000 (the leading small cap index) was the leading index last year, it is the loser so far this year.

This change in tactics by traders has certainly left many individuals wondering what has happened as they jumped into the Amazons and Tesla Motors at the top, only to lose 30%.  The stocks they sold to buy Amazon and Tesla were the large cap dividend stocks, and now these are the “hot” stocks instead.  If the typical reaction occurs, which I would expect, then individual investors will be running to these new areas just as the traders decide to run somewhere else and the investors will, once again, lose money and wonder why.

However, what is more interesting to us is that as the markets have moved to the dividend plays, they have started to sell off a number of very attractive companies that don’t pay large dividends because they are actually growing their businesses.  There will be more money made by purchasing companies no one wants for the moment rather than trying to chase the current market movers.  Not only are you buying companies that are on sale, but also you are buying based on economic fundamentals rather than emotion of what is up in a particular moment.

What is Up (Really Down) with Bond?

Interest rates on the ten-year U.S. treasury have fallen quickly this year.  As of 12/31/13, the yield was 3.03%. As of May 31, the rate was 2.47% – an 18% move in rates and a full third of that movement came in just the past two months alone!  To put it in perspective, the Dow was up 0.85% during that time period and the NASDAQ was up 1%.  Much of this was short-covering from speculation late last year that interest rates were going to rise.  What the markets seem to be anticipating now is that rates will be stable for some time.  With the expectation being that the Fed will start to raise fed fund rates by the end of the first half of 2015, the flattening curve would suggest that the markets expect that rates will rise slowly and the U.S. economy will continue to recover slowly, but enough that the Fed won’t have to help it with further types of QE.

This corresponds with market pundits who expect earnings to pick up in the second half of the year as the economy picks up steam.

Which Way will the Markets Spin Next?

Speaking of the Fed, we note that in recent speeches, Janet Yellen, the Chairman of the Federal Reserve, has made it clear that there is a new definition of full employment.  Remember that it has been the guidance from the Fed under Bernanke that rates would stay low until unemployment was down into the mid 6% range.  Well, officially, we are there.  However, the new chairman has made it clear that her definition of unemployment includes people who have been out of work long-term or those that only have part-time jobs (a very atypical definition).

While this may be noble and a great conceptual goal, it also says that the Fed is not going to stop easing any time soon.  Which makes me wonder about the current expectations for stocks and bonds.  If the Fed is going to keep rates low because the growth is low, then how do we justify stock prices that have already taken at least 18 months of future growth into account?  If growth is going to be strong enough that stock prices should rise, then how can the Fed keep rates so low?  Or are we in a some stalemate where growth is low enough that the Fed’s low interest rate environment won’t cause inflationary issues but high enough that company earnings do grow a little bit?  If this is the case, we should have a stagnant stock market and bond market.  But given the leverage in the system being used by speculators, you can’t afford to have a stagnant marketplace, you need volatility.

The Bottom Line…

We are suspicious of the perfect scenario that much of Wall Street is currently painting.  Stock prices are high, margins are at highs, and earnings seem to be slowing.  Company expenses will rise due to industry and new tax regulations (read: healthcare).  Given current valuations and leverage and adding in that the late summer months are often volatile and we have not had even a 10% correction in three years, and it would take very little to upset this perfect scenario.  Thus, we would continue to keep a close eye on portfolio valuations, take profits when you cannot justify valuations, and continue with a portfolio that blends equities, fixed income and commodities to try to hedge potential market volatility.

Alan E. Rosenfield, Managing Director

June 2014


Comments are closed.