Equity Markets De-Risking
The mid-point of September 2009 marked the one year anniversary
since the fall of Lehman Brothers. Interestingly enough, since that
period many stocks that experienced strong performance since March
2009 have started to experience substantial corrections. The market
appears to be de-risking as many small and mid-cap stocks have
taken major haircuts, while a number of larger capitalization
stocks appear to have held steady, if not improved, illustrated by
Exhibits I and II.
EXHIBIT I: SELECTED SMALL CAPITALIZATION NAMES
[click to enlarge]
EXHIBIT II: SELECTED LARGE CAPITALIZATION NAMES
[click to enlarge]
The US economy is facing both cyclical and structural economic
issues which in turn has made market participants question the
strength of the recovery. This may have led to a shift in risk
appetite with investors rotating from higher beta, smaller names
into larger companies that offer well recognized products,
services, and brands with stronger balance sheets. These companies
can presumably withstand further economic pressure compared to
smaller companies that may have less dominant market positions and
have greater financial leverage.
One big concern is the strength of the recovery and whether the
US consumer will be a leader in it. It appears from reviewing
economic data, financial media, economist opinions, and anecdotal
evidence that this is unlikely to happen. As a result, it's easy to
find many skeptics when it comes to equity prices. However,
investors may be ignoring the ability of companies to manage the
cost items of the income statement as well as the ability of
companies to manage working capital accounts on their balance
sheets, in essence enhancing their ability to generate cash and
For example, while sales have dropped considerably for many
companies, management teams have slashed corporate expenses to such
a degree that SG&A has scaled down even more aggressively than
sales declines. In addition, with many commodities and input costs
declining, gross margins have been able to hold steady. Given the
aggressive reduction in corporate expenses, stabilization in sales
declines can have a very pronounced impact, even without the
benefit of a V-shaped recovery.
Example I provides an illustration of how this can work. In
2008, Company X generated sales of $1B with gross margins of 40%.
At the time, due to its scale, SG&A was $250MM resulting in
EBIT of $150MM. Assuming there was no financial income or expenses,
a 40% tax rate, and 100MM shares, Company X had EPS of $0.90. Now
let's fast forward to 2009. Based on three quarters of data,
investors can reasonably assume the metrics presented in Example I
EXAMPLE I: COMPANY X
Due to lower commodity and input costs, Company X has managed to
improve gross margins. In addition, perhaps there is less excess
inventory relative to 2008 when the global meltdown occurred,
resulting in companies aggressively discounting their products.
With Company X controlling its inventory along with reduced input
costs, gross margins have actually increased. Keep in mind that H2
2008 resulted in many companies and customers "shutting down" in
terms of willingness to purchase just about anything. This was
illustrated in the devastating GDP figures in Q3 08 and Q4 08. So
with reduced inventory, reduced input prices relative to 2008, and
customers feeling that the worst may be behind them, gross margins
have improved. Second, Company X has reduced its cost structure at
the SG&A level. While sales in 2009 will decline by 20%,
SG&A has been stripped out by 30%, resulting in the same EPS
despite a much worse economic backdrop.
This has become an issue for many market observers that note
that earnings beats have been driven by cost cutting as opposed to
top line demand. This may not be as large a problem, however, if
even a mild recovery occurs. Example I projects that in 2010, sales
may increase by 7.5% from 2009 levels. This is hardly robust growth
from an anemic bottom. But assuming gross margins remain level with
2009 and SG&A increases by about 3% as work weeks and worker
demand slightly increases, Company X - despite sales levels 14%
below 2008 levels - can generate a higher EPS in 2010.
One thing investors should note is that PE contraction likely
occurred in 2007 and 2008 such that Company X's 2008 EPS of $0.90
may have been valued at 6.0x EPS, making Company X worth $5.40
early in 2008. Perhaps as 2009 has demonstrated, a severe and
complicated recession is what the US is facing as opposed to the
Great Depression II and therefore Company X can be valued at 8.0x
2009 EPS of $0.90 or $7.20. This 33% gain may just be part of the
normalization process from Armageddon to awful.
However, investors should question how 2010 EPS would be valued.
Presumably things should be improving in 2010 and 2011 should have
a better outlook as well. Would a 10.0x EPS multiple or 12.0x EPS
multiple be warranted or plausible? Even if the market elects to
value Company X's 2010 EPS at just 8.0x, the value of the stock
would be $8.08, 12% higher than 2009 levels.
Example I is intended to solely provide a back drop for how
investors may wish to analyze potential investments on both the
long and short side. Indeed, if Company X's valuation rocketed from
a PE of 6.0x to 25.0x and was still facing the same, weak future
prospects, shorting Company X could make sense. However, across a
number of stocks, particularly in the more volatile small and
midcap space (the stocks that have acted like those in Exhibit I)
which have fallen 20-50% from their recent peaks, market observers
may be missing an interesting entry point.
Commercial Real Estate
Shorting equities in 2008 was a slam dunk which has led many
pundits and financial media to spend considerable time on items
such as levels of government debt and the impending commercial real
estate ("CRE") collapse as investment themes for 2009-2010. CRE is
a risk but may not be the market killer many fear. This is in part
due to the wave of bank consolidation that occurred in the early
1990s through the most recent crisis. Basically the big banks got
killed by CRE in the early 90s and actually learned their lesson.
The big banks were killed by derivatives and more residential
exposure while the smaller banks took on the CRE.
The problem is that CRE is held by regional and smaller banks
which is why many have lagged the larger banks in terms of
performance. Regionals don't have the capital market businesses
that larger banks do, so they are stuck trying to rebuild capital
reserves based on the yield curve. In contrast, those with capital
market businesses have had the chance to rebuild capital faster
given their ability to participate in the volatile markets. What
could pose an issue is the new line that the government is drawing
between Too Big to Fail ("TBTF") and everyone else. "Everyone else"
are those that are holding a lot of bad CRE.
Successfully shorting these types of banks would require
examining the CRE exposure of the many small and regional banks.
Another possibility could be sifting through the FDIC's Troubled
Bank list and finding suitable candidates. Shorting REITs may also
be an idea to consider as the stocks have performed extremely well
since raising equity in the spring. The risk of a complete failure
for many REITs has subsided due to the equity raises. Those actions
saved many REITs from the abyss and that, combined with a major
contraction in credit spreads, benefited highly levered equities
like REITs, propelling those shares. However, given expected
occupancy levels, rents, and cap rates that still have not quite
blown out, FFO valuation metrics may be ahead of themselves for a
number of REITs.
Nonetheless, while many banks will continue to fail due to CRE
and other economic problems, investors should note that the impact
in terms of managing portfolios could be relegated to specific
areas. The major banks control the lion's share of assets such that
hundreds of bank failures may have very little overall impact
compared to 20 years ago when assets were less concentrated.
However, one theme that could play out is that as CRE impacts
smaller banks, larger banks could benefit as the supply of
available credit continues to contract, further strengthening the
banks on the government dole.
Rent It, Don't Own It
US investors have already experienced our first lost decade, and
simply holding on to equities since 2000 generated a much different
return profile than what investors - and frankly the majority of
investment managers - experienced from 1982-2000. Unless certain
investments in one's portfolio are designated as extremely high
conviction and offer multibagger possibilities, enduring high
levels of volatility can be costly. This is not advocating a
holding period of just days but investors should remain nimble and
focus on both the long and short side of portfolio management.
Any views expressed herein are provided for information
purposes only and should not be construed in any way as an offer,
an endorsement, or inducement to invest with any fund, manager, or
program mentioned here or elsewhere.
Don't Expect the Resolution Authority to Be a