On Wednesday, futures started the day quite strong, and cash indexes never looked back. Positive news from export oriented economies like China and Australia sparked the rally. Australia produces many raw materials and exports them to China, who then exports finished goods to the rest of the developed world, so positive news from these geographies may bode well for growth.  A positive US manufacturing report fueled the rally and offset a weak private employment.  

Markets rose nearly 3% led by materials and financials.

During a dismal August, investor sentiment has been extremely negative and stock prices reflect that. So even modestly positive news coupled with low valuations could have stocks coiled to continue on an upward path the rest of the year.

Gerry Mihalick

Wednesday’s Final Tally Below

I pointed out several companies in our portfolio which have ROE’s in the high teens to low twenty percent range, (or higher) which after adjusting for a 40-50% dividend payout ratio, should equate to a EPS growth rate of approximately 10-12% – higher than the market’s 8-9% estimated growth.

 But the analysis can and must go deeper at Berkshire:

 Any rationale investor seeking to own a business should start the process with 2 major questions in mind:

1)    “HOW does this company generate its profitability?

2)    “Is this profitability CONSISTENT AND SUSTAINABLE?”  (i.e. what are the threats to the cash flow?)

 Utilizing the DuPont formula, ROE can be broken down into its component parts and help answer those questions. 

 ROE = Operating Margins x Asset Intensity x Financial Leverage x Management of Taxes 

 The breakdown provides a road map for analysis for virtually any company in any industry:

 Operating Margins:

• How profitable is the core business?
  • What type of pricing strategy is the company following?
  • What kind of pricing power exists?
  • How does the company differentiate its products?
  • Can they charge more for this differentiation?
  • How economically sensitive is the company’s revenue?
• Asset Turnover:
  • How capital intensive is the business?
  • How much shareholder capital needs to be reinvested to maintain growth?
  • What level of fixed costs need to be covered to maintain break even status?
• Financial Leverage:
  • How does the use of debt magnify returns (or losses)?
  • What does management do with excess capital?
    • Buy back stock
    • Pay dividends
    • Reinvest back into the business
    • Make acquisitions
• Taxes Efficiency
  • How well does the company manage its tax obligations?

 Applying the Formula:

There is no “right” number for ROE or its components. It’s all business and industry dependent.  A company with stable revenue can handle more leverage (think consumer products, pharmaceuticals, or subscription based services) than a company with volatile earnings – (think energy, commodities or materials).

For example, operating margins for many steel companies at the peak of the cycle in 2008 rivaled that of many high margin consumer products companies. But a longer term look at DuPont analysis shows low to negative operating margins during many normal part of the cycle. Now our research indicates more steel capacity has come on line, demand has dropped, and margins are likely to fall – showing that ROE’s (and earnings growth) recently enjoyed by this sector are not sustainable.

In my next post, I’ll show specific examples of how we’ve used this type of analysis to make portfolio decisions.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

 Earnings growth should equal its ROE MINUS what the company pays out in dividends over time. If a company generates a 20% ROE and pays out 50% as dividends, earnings should compound at 10%. Importantly, dividends should also grow at the same rate as long as management keeps the payout ratio constant. This demonstrates why a high, expanding or at least stable ROE is desirable for growth of dividends. Analyzing the four levers helps an investor determine dividend safety and sustainability of earnings.

US stocks are on pace to post about a 14% ROE and estimated to pay out about 47% of earnings (as estimated by Thompson Baseline). So the long term sustainable growth rate of earnings and dividends should approximate 7%.

Our portfolio is packed with companies that we believe can grow earnings and dividends at above average rates based on ROE evaluation.

• 16% of our model portfolio has an estimated ROE above 20%
• 38% of our model portfolio has an estimated ROE of over 16%
• 65% of our model portfolio has an estimated ROE at least equal to or greater than the average US stock.

Approximately 15-20% of our portfolio has an estimated ROE that is temporarily below average, but we believe their businesses are rebounding. ROE’s should once again outpace the average stock in the market. These include a few large cap financials, and consumer discretionary stocks.

This is why we are of the opinion our portfolio can generate growth in dividends and/or cash flow at rates in the low teens.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

 On a security basis, about 2/3 of our selections are ahead of the market, with notable strength in selected financials, consumer staples, and domestic airlines. Stocks that are lagging the market include a major car rental concern and a domestic wireless carrier. In both cases we think the valuation/risk trade off still warrant ownership in our portfolio.

The relatively soft (but not disastrous) economic data released of late validates the average positioning of the portfolio. We are allocating client capital to big liquid companies with global footprints that we believe can generate high returns on capital, healthy free cash flow and dividend growth even in the face of economic headwinds. We believe the energy and commodity space do not possess this ability and earnings estimates are too high against the back drop of deleveraging, excess global capacity and tight credit.

Two companies in our portfolio made announcements this week.  

JPMorgan Chase (JPM) held an investor presentation whereby they articulated their outlook. The bank estimates its normalized earnings power is over $5.50 per share. We estimate, over time its true worth is over 10 times that number. The bank reiterated that provisioning remains adequate and credit conditions are stable to improving.  

Coca Cola (KO) announced their intentions to buy the North American operations of their largest bottler in a transaction valued at nearly $13 billion. The stock fell on the news. We think the transaction makes the company more capital intensive, reduces returns, and could weigh down earnings until 2012.  KO believes the model of simply collecting royalties by selling concentrate to its bottlers in an increasingly niche oriented and fragmented beverage market no longer makes sense. These products require more control over the bottling, marketing and distributions according to the company.   

 We welcome your comments and questions.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

There were two important themes to our purchase some time ago – falling oil prices and capacity cuts. We wanted to own companies whose earnings were sensitive to falling oil prices (as opposed to those who hedge). This has worked out and every 5$ drop in crude adds significantly to the earnings for many carriers. It is ironic but it was actually high fuel prices that put the airlines in the more favorable position they are in now. They forced the carriers to cut capacity, right-size their fleets which lowered their overall cost structures and firm up pricing.

These tough measures were all being implemented before the economy turned down. Additionally, as the economy really started to decline, oil prices fell even faster than anticipated which helped out even more.

As an added bonus, many companies have successfully embarked on various cost cutting initiatives. These are making meaningful improvements to the bottom line. The rough environment experienced over the last few years have forced the carriers to be disciplined in capacity and cost cutting, and they’ve made meaningful strides.

Now, volumes have either stabilized or increased. That’s a combination which creates a tremendous amount of earnings leverage – particularly as the companies swing to profitability. We still recognize these are extremely risky companies with weak balance sheets, but believe if their fundamentals continue to stabilize they may still have some additional appreciation potential.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in airline stocks.

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

We’d like to think with improving (but not great) fundamentals and lower (but still not screamingly cheap) valuations, stocks are set up to do better in the next ten years than the last ten (not a high bar!). So if ever there was a time to say  “out with the old and in with the new”, this would be it!

We have been of the opinion for some time that passage of this legislation would throw yet another wrench into tight credit markets and slow the eventual recovery in housing. Why? The end buyers of mortgage securities are one of the most important links in the securitization engine. Securitization (turning loans into bonds) allows mortgage credit to grow and flow freely around the globe. If judges were granted the ability to arbitrarily change contractual mortgage terms, balances, limit foreclosures etc, mortgage bond buyers will be less likely to purchase mortgage based debt in the future. Or, they will simply demand higher interest rates to compensate for the increased risk of a third party changing the terms of their bond during their ownership.  This of course will raise  mortgage costs,  and slow the flow of capital, and continue to depress home prices even further.

So what is the good news? According to Forbes Magazine, Mr. Dent now has a book called, “The Great Depression Ahead.” He predicts the Dow is going to 3600. Let’s hope this prediction turns out to be as a good a contrarian indicator as his last one was.

Lewis has compiled an excellent anthology of articles from modern day financial crises. Lewis reprints (along with some of his own commentary) some of the seminal news articles, white papers, interviews and government reports from past financial panics such as: the 1987 Stock Market Crash, The Asian Currency Crisis of 1997-1998, The Russian Debt Crisis of 1998, the Collapse of Long Term Capital, The “Dot-com” Crash of 2000, culminating in the current Sub-Prime Mortgage Crisis which unfortunately is not quite over.  Lewis lays out the articles in a way that captures the mood and sentiment before, during and after each crisis.

A few things are striking about the book. The first is the format. The anthology format allows the reader to skip around and focus on areas which are the most interesting to him. For example, I enjoyed the finer points of the policy dilemmas facing monetary officials during the Asian Debt Crisis. Do you raise interest rates to defend your currency (at the expense of already weakening exports), or lower them (and risk massive capital flight and deleveraging?) Lewis’s experience as a bond trader at Salomon Brothers yielded some very interesting insights into the debacle at Long Term Capital (“How the Egg Heads Cracked” which Lewis personally wrote for the New York Times in 1999.)

The second is how eerily similar each crisis seems to unfold. It’s almost as if there is a custom made template for financial panics. All you need to do is fill in new dates, the new financial instrument and change the names. The story is almost always the same: 

• A new financial innovation or asset class gains prominence.
• There is a view the innovation has tamed risk.
• The innovation produces fantastic gains for institutions.
• There is a central figure who rises to “rock star” like status and fame (think: Henry Blodget, Jack Grubman, and Michael Milken).
• Stories of ordinary citizens getting obscenely rich proliferate through the main stream media (“dot-com” day traders, Beardstown Ladies, condo flipping bar tenders etc.).
• A prominent member of the financial community stands up and warns of impending risk.
• They are ridiculed and dismissed.
• The bubble bursts.
• Panic ensues.
• The fall out is viewed as destabilizing to the overall financial system and the real economy.
• Congressional hearings begin.
• Society spends considerable resources trying to figure out how this could happen. It turns out no one knows how the first domino falls. The only common denominator seems to be a massive under pricing of risk. Lewis’s opening commentary on quantitative risk management (Value at Risk, Black Scholes etc) is particularly on point.
• Most importantly, once the panic ensues, in almost all cases, there is a prevailing view that the crisis is absolutely insurmountable.
• The storm passes.
• A new bubble forms.

My only complaint about the book is that it did not address the Real Estate Crisis of the early 1990’s, or the bursting of Japan’s Real Estate Bubble, both of which are much more akin to what is happening in America now.  Much of the book revolves around panic surrounding financial and quantitative innovation, however.

What are some of the broader perspectives investors can take away from reading the book? Risk cannot be tamed through mathematical models. They simply cannot predict how humans will react and adapt while under stress.

Panics crashes as well as opportunities have been around for centuries. The list of panics is long and they happen with alarming frequency.  The names, faces, dates and values change from crisis to crisis, but the story line stays the same. While this current crisis is a nasty and deep one, investors would be wise to remember the predictable story line of “Panic” also includes the word “Recovery.”

-Gerard Mihalick, CFA