Quick one today.
Chair of the Federal Reserve Board of the USA, Janet Yellen, gave a much-anticipated prepared speech at the annual economic symposium of central bankers in Jackson Hole, WY.
Her comments were initially interpreted as "hawkish" or leaning more on the side of raising rates with such comments as:
So all of those comments could be seen as positive for the US economy and arguably somewhat negative for bonds, in general, and other risk assets like stocks as it would seem the Fed would start a rate hike program, or at least continue the one they started 9 months ago.
However,I noted one odd statement. If she/they think the US economy is so strong and they are about to raise rates, why on earth did she also say:
As I said on BNN last week, "the Fed has been dead wrong and largely spend their time attempting to jawbone the market so they don't create bubbles in stocks, bonds and other asset classes".
The result in the market was arguably the opposite of what the bulk of her speech was all about....more hawkish than anything else -- the US$ got smacked down and when the US$ moves weaker, like today, then assets that are priced in US$ move higher (you can buy more of them with a weaker US$).
So pretty much everything went up. Probably fair to say the Fed is trapped in a box here. I still maintain they talk a big game about how strong the economy is but the reality is that they are scared spit-less about deflation and raising rates prematurely and creating one nasty recession.
I write to you today a "beaten-up" man. Thankfully for you, we have not been beaten up in the market, quite the opposite, but I am beaten up physically and emotionally. On Thursday morning, 7 of my closest friends and I were on our road bikes on our way to ride from our homes near the Leaside area to Muskoka (to Jonathan's cottage). Most of us have ridden the 217km route several times and last Thursday was to be no different. Unfortunately, a couple of us made it only about 25kms. After about 7 years of riding together in rain, sleet, hail, heat, cold, snow etc with no crashes, three of us went down hard. I went down first, then my good friend Ross and then Rob. Ross broke his arm about 5cm above the plate where he broke it mountain biking in November. Rob bruised himself up on my bike frame...he claims his cheek bone broke my top tube (picture above). A few of us felt pretty beaten up but also very lucky as there was traffic around and we managed to avoid what could have been. So as I sit gingerly at my post this morning, trying desperately to avoid sudden movements with my hips, glutes, elbows and knees (who knew road rash stung so badly...doesn't look so bad, but boy does it hurt), my friend Ross should be coming out of surgery on his arm. But hey, cycling is supposed to be good for you and a great way to stay fit!
The last two blogs I have written, I have laid out our overall research process in Part I and then our fundamental research process and cash flow analysis in Part II. Today I will conclude with what the heck we do with all of this research. The title of this one could be more appropriately called " The Decision Making Process", but I leave the theme running for continuity.
The first thing to know is that we don't just do all of this fundamental work each quarter, walk away and come back the next quarter when companies report their financial statements (earnings season). It is very much an ongoing process. For example, if a piece of news comes out either directly on a portfolio company, a company we follow or even one in a similar industry, we then take that information/news and look at it in the context of our portfolio company. IE, was there a takeover in the industry and at what valuation metric and how will that new valuation affect the trading price of our portfolio company?
Second, we tend to look at things through three lenses: fundamental, technical and flow.
Fundamental research, which I have talked about a the past two blogs, forms the base for our view. No need to explain it further here.
Technicals, or charts, help us ascertain good entry and exit points. Some examples:
And then we use "flow" to help us as well. Flow is what type of flows we are seeing/ hearing from the sell-side dealers. As an example, we might hear that there is a big seller of a particular stock or bond out there so even if we like it fundamentally and technically, we may just wait so as not to get run over by a freight train. This is where contacts and relationships (office mates, sell-side counterparts, the fact we manage $100mm for BNS) are invaluable tools for us...having our "ear to the track", as we like to say.
So the analysis of all three of those items (fundamental, technical and flow) go into the mix each minute of each day but there is more on a weekly basis.
On a weekly basis (Thursday mornings at 8:30am) we have an Investment Committee Meeting (ICM). The purpose of the ICM is to provide even more structure and dialogue to our research process. Scott and I will engage and discuss everything from our top-down view to our risk exposure to our view of Trump vs Hillary...and everything in between.
The other important thing we do at the ICM is we run a report on absolutely every account we manage. Because we do not manage "funds" (we manage all client portfolios on a Separately Managed Account basis (SMA)), we need to go through each account with a fine-tooth comb. Fortunately, we have two things that make this process extremely efficient: 1) Bianca (who is extremely proficient in such matters) and 2) Excellent portfolio management software that spits out an excel file on all of of our accounts and all of our positions.
As part of our risk management, we then go through each account and each portfolio company line by line to see who is overweight versus our model weight (if a stock or bond went up a lot) or who is underweight versus our model (if new money came into an existing account or a new account was opened). Then we need to make buy/sell decisions and we go back to fundamentals, technicals and flow to determine what and when we will buy or sell to get those clients to the model weight. Scott talks a bit about "re-balancing the portfolios" and this certainly comes into play here each week during our ICM. Rest assured, we understand each client's risk exposure at all times.
Now all of this experience, work, research, discussions,meetings etc in no way guarantee great performance. What it does do is, it puts structure around our process and, we believe, sets us up to, at a minimum, give us a fighting chance against what is a very tough thing to do...invest profitably so as to achieve our collective.future goal...a comfortable retirement (although I probably will never "retire" from doing what I am doing).
Yesterday I explained our research process as it relates to the top-down/bottom-up work that we do. This is about Disciplined Investing, as is our motto. It would be pretty easy to read sell-side research reports and consider that enough "research" to do and then to go fishing but that is not how we do it.
So today I will delve down a bit deeper into our bottom-up/micro/fundamental research process. As I said yesterday, I run excel files on all of our portfolio investments. Each company has an excel file and it is an ongoing process. There are several tabs in each file, as described yesterday, but one of the most important is the Cash Flow tab where we track historical financials and model the future cash flows and capital structure (see here for capital structure explanation: http://highrockcapital.ca/pauls-blog/an-introduction-to-the-capital-structure-of-a-corporation and-how-to-be-tactical) of each company.
Here is an info-graphic that I have used the past couple of years when I have been invited to be a guest lecturer at Queen's University's Master of Finance Program:
We start with Revenues (often referred to Top Line...harder for a company to manipulate) and then work our way down. Ebitda (Earnings before interest expense, taxes and depreciation and amortization) is often referred to as Cash Flow but it really is only the starting point. We need to take Ebitda and deduct items the company REALLY need to pay for (called Fixed Charges) like Interest Expense (if they don't pay that, they are in Default), and then Cash Taxes (some companies don't pay cash taxes because they have Net Operating Losses but if they do need to pay cash taxes, they really do or...they will end up in jail!). Also, most companies have to spend a bare minimum on their business. This is called Maintenance Capital Expenditure (Capex) which is the money spent too keep the business rolling forward (like doing basic repairs around your home). (Growth capex does not Need to be spent so we don't necessarily include it).
Then we get to Free Operating Cash Flow (FOCF). It is from here that companies can distribute Dividends to their shareholders. This is a key determinate in assessing a company's ability to pay Dividends. As you can see, we calculate the Dividends Paid as a % of FOCF. This is KEY if you are a Dividend Investor.
Not on the graph above but then we calculate the Capitalization (Capital Structure) of each company noting what the Covenants (Limitations on what the company can and cannot do) in their Credit Facility (Bank Debt) are track them each quarter. We do the same if they have bonds outstanding (especially High Yield bonds). This requires a ton of Legal reading as all of this information is found in Legal Documents called Credit Facility Agreements and Bond Indentures. They can be 250 pages long and are definitely not night time reading. Perhaps boring, perhaps a lot of work but extremely important.
Then we track how the Cash Flow Model compares to the Capital Structure to derive and compare their "credit metrics" with their allowances under their Credit Facility and their Bond Indenture. This is called "Headroom". Should they get close on their Headroom their securities (stocks and bonds) will start getting nervous and selling off.
So that is the more in-depth work I do on each portfolio company (and many more at about 50 of them). This work is done initially and then quarterly as each company reports financials on a quarterly basis. This is the type of work our clients are paying for as we believe it helps us in our investment decision making process. It doesn't guarantee success in our investments but it sure does lend a solid level of confidence and takes advantage of where others may not be a Disciplined in their process.
Next week I will attempt to describe what we do with all of this fundamental research and how we actually execute in our portfolios. Part III coming up...
Given Scott is on a well-deserved vacation in the complete wilderness that is the Yukon, and is obviously not able to write his normal daily blog, I thought I would attempt to step up and write a few. (We also will not be hosting our regular weekly webinar this week nor next).
My role at High Rock, among other things, is to do some macro research (largely nighttime reading for me), manage the portfolios and the risk and to do all of the bottom-up, fundamental research that we base our individual security selection on for bonds, stocks, convertibles and any preferred shares.
Today I thought I would describe our Research Process that we base our investment decisions on. At High Rock, we view our research as paramount to our collective success. We don't just buy securities...we believe that our hard work, experience and education in security analysis and our years of experience in actually trading/investing for a living help us succeed. So today I will broadly explain our research process.
We start with a blend of Top-Down and Bottom-Up Research. We attempt to get the "big picture" right first and then do the bottom-up individual security research. For example, we had a macro view in Feb/16 that oil (and other commodities had bottomed and wanted to get long energy securities. We then did our micro research and picked not only the right companies but the right securities (stocks then bonds).
Top-Down/Macro - this type of research is the "big picture". It involves analyzing central bank moves, currencies, commodities, interest rates/government bonds, economic statistics, etc. Scott is primarily responsible for guiding our Macro view of the world but I obviously spend a fair bit of time on it as well.
Bottom-Up/Micro/Fundamental - this is the detailed analysis we perform on each company we invest in. We run excel file models on our portfolio companies and keep the models up-to-date at least on each quarterly financial report by each company. This could be seen as a combination of financial statement analysis and accounting. More on this tomorrow. I do all of our bottom-up.micro/fundamental research.
A brief explanation of our process from the info-graphic below:
Idea Generation - this comes through reading the press, sell-side analyst research reports and most importantly, our business associates/contacts (doesn't hurt that we share office space with the Smartest Guys on Bay St).
Excel File - if we are serious enough, we open a new excel file. Every portfolio company has an excel file/model. (Ask your current Advisor to show you his/her own, proprietary research models...)
Notes - we then get up to speed on the company, the industry etc. This tab contains the quarterly conference call notes, any discussions we had with the management team news, etc
Cash Flow - the most important tab is our analysis of the company's cash flow. More on this tomorrow
Covenants - pre-2008, equity analysts never even looked at credit facilities and bonds and the covenants that were in place. Today, most do. We sure do as one needs to know what limitations the company is under at all times
Operations - depends on the company but they all sell or produce something so best to keep track each quarter
Relative Value/Valuation - tricky for sure and as much art as science but we look at similar company's valuations on different metrics
Org Chart - want to know which legal entity issued the bonds or stock. We prefer to be as close to the operating assets as possible
Decisions - then we make our buy/sell decisions based on all of this research
So there you have the meat on the bones of our Research Process. It is well-defined and works for us (and our clients). It is a lot of work (especially during reporting season) as I have excel file models on about 50 different companies but it is extremely important work to perform.
I once worked with some individuals who's idea of "doing research" was simply reading sell-side (banks) equity analyst research reports! Really? No real research done. We do look at equity analyst reports but more to see what they are forecasting and if they are too optimistic or not optimistic enough...our goal is to be ahead of them because they publish their research and Advisors regurgitate what the Analyst says so it does create "flows" in a stock. Sell-side analysts are also rather conflicted because the companies they report on are Investment Banking clients of the bank (another story).
To invest without doing this in-depth research is probably more like gambling than investing.
I have spent 30 years trading, investing and managing risk for a living and the last 18 of those years I have been deeply involved in what is called credit.
Credit is broadly defined as corporate debt or corporate bonds but encompasses all kinds of crazy derivative instruments (including the kind that blew up the world in 2007/2008...remember they called it the Credit Crisis?). Anyway, when I traded credit at Merrill Lynch Canada for 10yrs as the Head of Canadian Credit Trading, I was fortunate enough to be there at a time when the firm wanted guys like me to take a lot of proprietary risk. The banks and dealers back then (pre 2008) were really giant hedge funds.
What was interesting about what we were allowed to do was to put risk on all across the capital structure of a company. That is to say, we didn't just buy corporate bonds, we invested in bank debt, convertibles, preferred shares and even common equity. And we didn't always just buy or go "long" positions, sometimes we would "short" or "sell short" other positions, in the hopes, based on our deep fundamental research, that our long positions would go up and our short positions would go down...The Holy Grail of Investing.
The real benefit of this skill, knowledge and experience is that this is real investing. To just look at buying a company's common equity (because that is all you have visibility on or can get your hands on) is myopic, to say the least. I will elaborate in a minute, but first, here is an intro on the capital structure of a corporation:
The first thing to know is that being at the top is best...more secure a position in case something bad happens to that company. If a company restructures or declares bankruptcy, you want to be invested as close to the top as possible. The bottom is the most volatile and usually weakest position but also has the most upside.
So at the top, we have Senior Secured Debt or Bank Debt. This is secured against all or some specific assets of the company so if there is a restructuring the Secured Lenders will likely get paid close to 100% of what is owed to them. Bank lenders are typically in this position but often some corporate bonds are as well. Bank Debt and Secured Bonds typically have a lot of "covenants" that the company needs to follow or they may find they are in default, which they obviously want to avoid.
Next down is Senior Unsecured Bonds (including High Yield bonds). So these bonds are not secured against specific assets and if there is a restructuring of the company;s debt, then typically the Senior Secured Debt gets paid 100% first and then the Unsecureds get whatever is left over. (This is called a Waterfall). Unsecured Bonds typically have covenants as well which are there to protect us as bond holders. So this is the next "safest" position to be in.
Then we have Convertible Bonds. These are tricky. If the issuer runs into cash flow trouble, they can actually convert not only your maturity into common stock but they can convert your semi-annual coupon interest into common stock too. Convertibles typically have very few, if any, covenants.
Preferred shares are near the bottom of the stack. As I said on BNN in April, Preferreds are not Fixed Income,but are Senior Equity. They may pay a coupon today but if trouble ensues, they can easily cut or stop that coupon entirely and there are no repercussions to the company. Not exactly a "safe position to be in.
And lastly, right at the bottom of the stack, we have common equity. Common equity are the "owners" of the business so if the business really takes off, the projection of improved cash flow will be seen in the stock price rising. However, if the cash flows sink, and they have significant debt, the common equity will get hit hard. Any dividend yield is simply a promise to pay, like Preferreds, not an obligation to pay like a bond. So Equity has the most upside, but also the most downside with $0 often being the result during a restructuring
OK, so armed with this info, and going back to my 18 years of experience trading and investing across the entire capital structure of companies, I will explain why it is so important and opportunistic to have this knowledge and experience when it comes to investing.
At High Rock, as I did at Merrill Lynch, we invest for a total return. That is to say, we follow benchmarks but we are always investing to create a positive total return. And this is important because we want to be invested in securities where we feel the best intrinsic value is or the best risk-adjusted returns (we talk about this a lot). If it is the common stock that might be the best part of the capital structure to invest in, then we will do so. If it is a bond, further up the capital stack, then we will invest there.
Maybe an example would help. For the past year, we were long the common stock of company A. Something at this company changed so we sold about half of our stock position and used the proceeds to buy a convertible bond issued by company A (we moved up the capital structure of company A). The reason for the switch was because we developed a feeling that company A might need to raise equity capital (sell common stock) and if they sell common stock, that capital comes in at the bottom of the capital stack so it inherently helps add "support" to the convertible bonds we bought and they would go up in value while the stock would go down in value because of supply. Company A has yet to raise equity capital but I can tell you that the stock has come off about about 5% and the convertible bond we bout is up about 1%...not much, yet, but it could be soon.
Another example was getting long some oil and gas producer bonds. When we saw these companies start to issue common stock, we rushed out and got long some of their bonds because that new common stock raise was inherently good for the bonds Some of these investments have done very well...maybe not as well as some of the stocks (we got long some energy stocks too) at their very bottom but 15-50% returns with lower volatility is nothing to sneeze at. .
This is being tactical and is what our Tactical Model is all about. This requires lots of experience, skill, knowledge, research, and generally having our "ear to the track" on all of the names in our wheelhouse that we do research on and invest in so that we can be one step ahead of the market.
That is how we take advantage of our skill, experience and the synergies with managing some high yield funds for Scotiabank. .
With US equity markets moving up and down at all-time highs, Scott has been writing and speaking (on our regular Tuesday 4:15pm Webinars) about why we are a bit more cautious on US stocks. Valuation metrics appear stretched and volatility, although low at the moment, has been whippy over the past 18 months.
I thought I would add a few charts to help show the bifurcation between the nominal level of US stocks and a few other valuation metrics.
First is Price to Earnings (orange), Enterprise Value to Sales (blue) and Enterprise Value to Ebitda (red). Remember, Enterprise Value = Market Cap of the stock, plus debt less cash and Ebitda = Earnings before Interest Expense, Taxes and depreciation/amortization. So when all three of these lines is rising, it is most likely that the price of the stock is rising faster than the company's underlying earnings.
So on two of these metrics (EV/Ebitda and PE), we are more stretched today than we were in 2007...and we all know how stretched we were in 1999...and what happened right after. If you don't remember the dot.com bust, focus on the middle of the above chart...
Next, we have two measurements that look at how well businesses are performing. Operating Margin and ROE (Return on Common Equity). Both have been sliding over the past two years which is obviously not good:
So if earnings are dropping (as Scott wrote about this morning) and margins are dropping, why are stocks rising to all-time highs...with GDP sitting around 2%? Maybe it is something else?
How about it's all driven by the Fed? Pretty strong correlation to the Fed's balance sheet, isn't it?
Maybe investors have run out of mattresses to stuff their cash in? Maybe they are afraid of getting taxed in their home country savings accounts? Maybe they are foreigners who are no longer going to buy Vancouver real estate?
The reason would appear to be one of relative value. Where else do you put your capital? There are well over $10BLN of government bonds around the world that have a minus sign in front of them. The problem with relative value in this particular situation is, it will not be different this time. Fundamentals always come home to roost.
At High Rock, we have arguably been pretty cautious on global stock market indices, however, we have been pretty bullish in our Tactical Model which invests in very specific, well-researched individual stocks and bonds. The Tactical Model has had some good calls on energy stocks and bonds (we have a completely unique ability to take advantage of high yield bonds in our Tactical Model) as well as a few other positions. We also have had a great call in some more traditional government and corporate bonds. The result has been very strong risk-adjusted returns for our portfolios, even though we may be under-weight some global equity indices.. We continue as is and wait for the broader market to provide us with a better entry point so as to reduce the unwanted risk.
Just about every "Macro Research Analyst/Strategist" out there looks at PE (Price to Earnings) multiples as the main metric to value both individual stocks as well as the broader market.
To be sure, this metric has some validity but it loses a lot of efficacy by the very components in it's calculation. The "E" is represented by "Earnings". Earnings are the "bottom line" on the Income Statement of a company's financial statements. Earnings come in two forms: 1) GAAP and 2) Adjusted or non-GAAP. (GAAP are Generally Accepted Accounting Principles). GAAP earnings are effectively "pure" earnings. Non-GAAP earnings are those that are "Adjusted" for such "one-time" events like legal costs, restructuring costs (layoffs), etc. All of these one-time costs are added back to GAAP Earnings to get to Adjusted/Non-GAAP earnings, which are obviously much bigger after these add-backs. Take Alcoa for example: They have been "adding back" about $1.2bln in "one-time restructuring costs" for years! And that is on Earnings of only $500m-$1bln that is apparently available to common shareholders. Its like a Ponzi Scheme...perpetual one-time "adjustments"
Now the next problem with PE multiples is that the "E" is actually EPS (Earnings per Share). So this can get rather manipulated as well as companies have been on a real run of buying back their own shares which decreases the denominator in our multiple thus making the multiple look higher, or even more expensive. The risk with a company buying back its own shares is obviously that they see no better use of their cash in their business either for acquisitions or for growth capital expenditures to grow the business for the long term. Remember, when we buy an individual stock, what we are really buying is a cash flow stream of earnings (and we need to value that correctly depending on the quality of that cash flow stream).
And the final problem with PE multiples as a valuation tool is the "P". The P in the numerator only takes into account the Price the stock is trading at. What about the Debt, which is part of the Capitalization of a company? It is not all just market capitalization (stock market price X number of shares outstanding). When valuing a business, we need to look a the entire capital structure of a company: Debt and Equity.
There is a better,way to value a business and this is the way businesses value each other , most certainly when they look at acquisitions. EV/Ebitda is Enterprise Value (market capitalization plus debt less cash)/Earnings before (add back) Interest Expense, Taxes and Depreciation and Amortization (and when we look at Earnings, we need be diligent in what was added back in before we even start the calculation). This is the most "pure" way of valuing a business as it encompasses the entire capital structure of the company - Debt and Equity are calculated in the EV. . Company A doesn't look at buying Company B and say" hey, they look cheap at a PE multiple of 15x, let's buy them". They do however look at EV/Ebitda multiples as a source of valuation. And so do banks when they extend credit through a facility - can you imagine a bank looking at just the market capitalization of a company...ie...the stock price, before lending credit to a company??
EV/Ebitda is, quite simply, the purest form of valuing a business. Think of the difference between PE multiples and EV/Ebitda multiples as "retail valuation" vs "professional valuation". Each company I do fundamental research on, I model out the EV/Ebitda multiple. Quite frankly, I do not model PE multiples at all...pretty much useless the way I see it.
Now, lets look at the EV/Ebitda multiples on the S&P500 (first chart) and the Russell 2000 (second chart):
Yikes! Look cheap to you? Not so much to me.