Credit Trends

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CT Capital llc Research

The S&P 500 has lost its utility as a value benchmark for assessing portfolio performance since it cannot match the broad sector composition, volatility of key financial metrics, cost of capital, employment, and its volatility, and other characteristics of measuring value-type equities.

The S&P 500 may be more accurately and currently characterized as a well-known quasi-technological benchmark. The US Bureau of Economic Analysis (Figure 1) shows the technology sector accounts for just 8.8% of GDP, yet the top 6 stocks in the index, all being technology, account for 27% of its portfolio importance.

Comparatively, during year-end 2017, the top 10 S&P 500 stocks were a diversified group accounting for 17% of the entire index value—today, the top ten securities for about one-third and is composed of a single sector–technology firms.

The current faster growth in many technology firms does not warrant its weighting. As we saw with Tesla shares, a top 5 S&P 500 firm only a few years ago, these shares can halve in value even though, as economic growth remains strong,  shares are generally rising.

Example: Nvidia’s stock price increase of only one day this quarter was about equal to the combined performance of two hundred S&P stocks!

Figure 1 Technology Sector in S&P 500 Gives Misleading Impression of US Economic Activity

 (figure sent to CT Capital Clients)

Because of the greater cost of equity (risk to adjusted cash flows) associated with technological companies, anticipated returns should consider a large depreciation of principle. Extreme volatility is inherent in the sector.

However, our diverse large capitalization value portfolios and the Russell 1000 Value Index have longer track performance records over a broader range of economic conditions and shifting industry trends, making them less vulnerable to the notable price volatility linked to a single sector. Conversely, as its complexion changed in very recent years, the S&P 500 became a general index oddity.

We display two large-cap value portfolios below (Tables 1 and 2). Their makeup differs significantly from that of the S&P 500 benchmark. Notably, those top heavy currently ruling the index are absent, except Microsoft, which logically has a more extended history.

 

Table 1 Wilshire 1000 Large Cap Value Portfolio Characteristics

(Table sent to CT Capital Clients)

Table 2 Russell 1000 TR Characteristics

(Table sent to CT Capital Clients)

Always remember that short-term financial results have a minimal impact on long-term value. In contrast, the consistency of multi-cycle growth in inflation-adjusted metrics found in a value portfolio such as CT Capital has a considerable influence and investor reward. That is the essence of a value-type portfolio and one not present in the current construction of the S&P 500 as has long been perceived.

 

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Our company has a unique approach to estimating the cost of capital. We believe that we have delved deeper into this matter than any other advisor. To make sure, feel free to ask other advisors about their precise method of calculating the equity cost of capital, including worksheets. While academia has also touched upon this topic, most focus has been on naive GAAP data and relatively simple approaches. It is essential to understand that even a one percentage point difference in the cost of capital can lead to a fair value variation of fifteen to thirty percent, depending on the current price of capital. Therefore, we must consider this aspect when determining a reasonable value estimate.

Become a CT Capital client today and understand our history of outperformance of benchmarks with considerably lower risk

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As security analysts, we conduct year-end assessments and profound financial modifications to reported results. The quantity and quality of the information initially disclosed at the commencement of the reporting period are typically limited in scope.

First, financial releases are frequently scant; thus, our methods for obtaining information become more varied. In addition to the company information that may have been available, we gather and use a variety of sources to broaden our base, including official government data, conferences, managerial approaches and remarks, competitor and supplier information, and other pertinent channels like state requirements.
Our primary objective is to understand the allocation and origins of cash flows comprehensively.
To that end, it is essential to conduct a thorough examination and analysis of all sources of revenue to gain a comprehensive understanding of the inflows related to cash flow. This includes examining all revenue categories, whether through cash receipts on earn-outs, product and service sales, or any other means of obtaining cash, such as insurance proceeds. We will make the necessary adjustments if we uncover any unusual cash production information.

 

TO VIEW THIS MOST IMPORTANT TEN-PAGE REPORT, YOU MUST BE A CLIENT OF CT CAPITAL LLC

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…….

Investors typically raise risk levels when normal cyclical events stare them in the face when they should have accounted for it all along, including current happenings in China.

The most significant such issue is in fact the expected dramatic population drop in China.

Japan was viewed as the world’s economic engine (Figure 1) and now China could well be on a similar track. Increasing sovereign risk further clouds their economic outlook, especially with the EU recognizing its threat to world stability. This month, Astra Zeneca announced it was spinning off its Chinese division for this reason.

 FIGURE AVAILABLE HERE ON CLIENT REPORT ONLY

 

 Figure 1– Stock Performance Tied to Population Growth as Seen in Japan

Firms with heavy customer/supplier exposure in China must cut operating costs and find new outlets and innovations to maintain or capture larger market shares

….

All our metrics are converted to real (inflation-adjusted) terms, offering insight in both inflationary and deflationary periods.

As with our Lockheed Martin, we fully expect quite a few of our holdings to continue closing out portions of their pension liabilities. Pension transfers doubled over the past year as premiums dropped as interest rates rose. Such actions improve credit, cost of capital, and valuation if key metrics remain constant or improve.

…

For lower credits whose asset quality (collateral) drops during periods of sector weakness, additional borrowings come at a high cost, often unable to be captured by the shrinking operating margins.

With world economies embarking on years, if not decades, of slowing nominal (relative to post-war) growth, our proprietary financial adjustments carry important significance in estimating fair value.

Example. The purchase or sale of a futures contract is listed as an investing activity in the statement of cash flows, even though the contract is intended as a hedge of a firm commitment to purchase inventory. Thusly, we would adjust to an operating cash flow. This would not be picked up by almost all analysts, if any.[1]

Starting with the following year, firms must disclose where and when derivative instruments and their related gains and losses are reported in the statement of cash flows. To the extent we derive additional information, it will be incorporated into our restatements.

It amazes us that the geniuses at the Federal Reserve do not recognize that the more they raise short-term rates from current levels, the greater long-term rates drop since the US is already experiencing a slowdown. Should such actions occur, cost of debt capital, assuming constant spreads, drops, defeating the Fed’s agenda for inflation restraint.

Any bank restraint will likely be supplanted by the “shadow banking system,” only a portion of which is regulated and could lead to future hard-to-control issues for financial regulators

[1] Ask other advisors the various adjustments they make to the published financial statements on derivative positions.

…

TAXATION

The 15% alternative minimum tax should result in unexpected consequences for many investors. Because the change is based on a rolling average three-year $1B back-test, firms may be required to pay higher taxes even though profits and cash flows drop.

In addition, an upcoming accounting standard on taxation can be expected to have a weighty impact on valuations, providing investors with essential breakouts of foreign, local, and federal tax (subject to a 5% threshold). The standard will allow for greater introspection of risk in which the various countries’ firms operate, with the result, our worksheets will have a closer margin to the estimate of fair value.

As generative AI moves up the curve, it will allow firms to prepare tax reports and insights either not possible now due to time constraints or records being held across a wide range of locations, customers, and suppliers.

When instituted, Pillar 2 requirements are complex and will cause investor havoc, but one which we will be fully prepared for. Pillar 2 has already been adopted by a large number of countries.

The 2017 Tax Cut and Jobs Act rewards our higher-than-benchmark credit portfolio, as it limits the amount of interest that may be deductible to 30% of taxable income. However, it permits depreciation and amortization to be deducted from the taxable income calculation.

Capital-intensive industries will be vulnerable to higher taxation as they can no longer fully deduct equipment expenses in the year purchased. This residual will lower valuation multiples for affected firms.

…

STOCK-BASED COMPENSATION

Investors tend to downplay the real cost of stock-based compensation.

As investors read the statement of cash flows, under operating activities, stock-based compensation is added, it being a non-cash item over that reported in the income statement.

But does this provide investors with all the tools they need to evaluate firms worth?

Stock-based compensation is far from a small cost, even considering the beneficial tax effect. The employer generally is eligible for a tax deduction equal to the full amount of the stock minus the exercise price when the employee vests in the restricted stock or the intrinsic value of the stock when the option is exercised. 

 

When a restricted stock vests or a nonqualified option is exercised, the amount of the employer’s corporate tax deduction is fixed.

 

Equity issuance, even for firms in our portfolio, given their valuations and credit profile, is costly and should be recognized as such.

We are not advocating firms not providing this incentive to current and future employees, but to generally recognize the cost into valuation when making the decision. Equity can help lower cost of debt capital when used judiciously in debt instruments.

Furthermore:

• Equity dilutes current shareholders, so additional cash flows could be required to maintain current valuation levels.
• If the tax deduction is less than the book compensation cost, the employer has a “tax shortfall.”
• BALANCE OF THIS SECTION SENT TO CLIENTS ONLY

 

HOW WE ADJUST OUR ESTIMATE OF FAIR VALUE WHEN A COMPANY REPORTS A SHORTFALL

Our fair value estimate may be altered when an investee reports a shortfall in their normalized key financial metrics. Under normal circumstances, a shortfall, either during a short-term period or cycle, has a quantifiable and limited impact in our investment process, as it has already been considered thru the cost of capital (see Commentary), or via our normalization restatements.

Such may be cause for an outright sale or, as written in our “Commentary” which follows, be already factored into our cost of equity. Each case must be tailored to the firm and issues involved, both quantitative and qualitative. As our firms are expected to see real growth from cycle to cycle, normal cycle or temporary issues of cost or revenue wash out over time, despite what investors believe at the time to be atypical.

The primary relevant factors are:

1. How does the shortfall impact our expected normalized real free cash flows and growth rate? What is the timing of any likely recapture of revenues delayed, discounted to current and fair value?

Identify the causes and whether they can be assumed to be of a longer-term duration. If so, for how many periods? If the shortfall was due to a significant client, supplier, geography, or external factor, is it……………………BALANCE OF THIS SECTION SENT TO CLIENTS ONLY

 

 

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We know bear markets are no fun.

 

Such is why we devote as much time studying risk as we do to the ability of a firm’s managers to generate cash from assets, all the while placing the firm(s) on course for future growth in normalized and adjusted cash-based return on capital.

 

Our firms have strong corporate identities (market share) with sound financial structures, and financial back-up (calls on credit) should such ever be required. Their alliances with the debt community are deep.

 

Bear markets, whether financially or otherwise induced, test the mettle of not just corporate managers but us as well in the delineation of our cost of equity. And on that score, you should feel very much at ease, as almost a half-century of analysis can attest.

 

Our firms will (not might or should) bounce back to new highs when the current period is over, a forecast that cannot be made about so many other firms whose share prices in the bull market were exaggerated and are now facing a period of rising interest costs and tax rates.

 

For example, many firms have counted on the bull market and contributed lower cash payments to their pension plans. Such maneuvers artificially raised GAAP-based cash from operations, an activity for which we adjust. Higher tax rates will also be in the cards for many firms due to changes in tax laws; a topic addressed in our last report.

 

Unfortunately, investors have not yet distinguished between firms like ours and other firms, even those benefitting from tax credits under the Inflation Act.

 

KH

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IMPAIRMENTS – A CT CAPITAL ADVANTAGE

Impairment occurs when fair value is below amortized cost. Some business decisions, including the sale of assets, could well result in an impairment charge.

Our cash-based return on capital model is excellent at catching future impairment charges under GAAP, especially as one of the tests in the Standard is a drop of total firm market value below book. We concern ourselves with impairments likely to reduce cash flows, as most impairments are recorded as non-cash GAAP events. The impact on future cash flows is to be determined.

Impairments may also lead to covenant violations due to cash flows or collateral impacts.

You recall the worldwide credit crisis was exacerbated by FAS 157 and its fair value provision, which forced firms to mark inactive securities to market. This was later replaced with other conditions, including the income approach used by our firms with no need to sell portfolio holdings to supplant cash and whose portfolio consists of non-active fixed income instruments. Assets for sale are shown in OCI (other comprehensive income), and currently show, for our portfolio, no deviation from normal.

Though the impairment-related Standard calls for an annual review, a change to interim reporting may be called for, especially for firms with inflated inventory and goodwill, the latter which may not be amortized or deducted for tax purposes. Impairments are normally set at the individual unit level.

Taxable M&A goodwill may result in tax-deductibility and needs to be studied, including the impact on future taxation.

Our cash flow-based models already incorporate fair asset values into our value estimate. Assets reported below their ability to produce cash are thus late to the game. The same is true for assets such as PP&E, which may be near the end of their useful life for accounting purposes yet are fully capable of producing goods for years to come.

The Inflation Reduction Act may prove to be the most important new legislation impacting cash flows and valuation, requiring a comprehensive understanding of firm accounting (both global and domestic) and actual cash tax. Tax credits and incentives have sway over taxes due otherwise.

The alternative tax provision for a minimum 15% based on a firm’s book income must be evaluated in conjunction with the many offsets;[1] as far as the 1% tax on buybacks is concerned, it is of minor influence, and could be overcome if the firm is to issue stock or to repurchase other securities. CT Capital has the abilities necessary to dissect the data in an appropriate form, which is then plugged into our valuation models.

Free cash flow estimates require getting the fingernails dirty and normalizing results, transactions, accruals, and estimates within the line entries, and, later, tax credits. Most analysts use simplistically lazy models.

[1] In this provision the Act generally establishes the 15% tax liability for firms having a $1B average annual adjusted financial statement income. It is an alternative minimum tax to the extent that its “tentative minimum tax” exceeds its regular US federal income tax liability plus its liability for the base erosion anti-abuse tax (BEAT). Impacted firms do receive a credit against future liability.

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Subject: FROM CT CAPITAL-A STORY AND LESSON FOR THE WEEKEND

 

Hi,

 

Quite a few years ago, the law firm I used was the same as Carl Icahn, where his personal attorney was a partner.

 

My attorney knew of my M&A client, who was vastly more well-known than Icahn for his takeover antics, including “greenmail,’ which at the time, while not illegal, had no additional costs to the threatened firm, as was later the case. My client bought a few leading firms and hence became one of the wealthiest men in the US.

 

In fact, I had several meetings with Icahn’s attorney for no reason other than an introduction.

 

When the news broke of his buying TWA, I was told he ran around his office singing: We bought an airline. We bought an airline.

 

I called my then attorney to tell him it was a big mistake, from unions to pensions to cyclicality, and other negative risks are thrown in, like fuel costs.

 

I thought of this and am happy Mr. Icahn learned a lesson he has wisely put to use since, as we see the historic rise in valuation multiples of firms with strong growing real cash returns over its cost of equity. This metric was undoubtedly not the case with TWA, later to file bankruptcy proceedings.

 

We see our owned firms, from the mega-cap Accenture to the small firms like Watts Water and Quanta rise a multiple of their cost. Yet had they been handed a large merger premium at the time of our cost would have been hailed by investors, and no more so than institutional investors.

 

Investors and firm executives who do not get the lesson here will always be doomed for underperformance, despite hitting the hot industry or trend from time to time. Investment advisors will see lots of journalistic coverage in the process, and the institutional money will flow, just as it did for the Paulson’s and other hedge fund managers post the credit crisis. Such is now the case with private equity, despite many risks for those firms, including size and transparency.

 

As the saying goes, all that glitter is not gold, and why our firms rise over multiple cycles without the benefit of fads or large cyclicality.

 

 

Ken

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Politicians were so adamant to get the hell out of fossil fuels they neglected to consider the unintended co of doing so as quickly as their campaign promises.

 

See our important report in which we discuss the impact to financial assets, which sectors and names stand to benefit, and more importantly, and in combination with stepped-up sovereign risks and changes to tax codes worldwide, those sectors and names which will almost certainly see their valuation multiples compress.

 

Kenneth Hackel, CFA

 

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Tesla remains our favorite short position, only enhanced by Musk actions the past few weeks. Comments this morning to be followed by updated review out this weekend.

 

 

KH

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With non-GAAP presentations rampant, the importance of our making financial statement adjustments is a critical component of our analysis. The energy sector is far from alone in this regard. Classification error in the statement of cash flows, where firm leeway is often permissible under GAAP, requires such adjustments and results in large ranges in free cash flow estimates for analysts not making proper adjustments, such as leaving activities as financing or investment cash flows instead of movement to operating. The unadjusted analysis would result in incorrect conclusions of target price and risk.

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Some 25 or so years ago we took the name Credit Trends and in 2002 took the website you see here.

Some years ago I called someone at Moody’s and asked them to refrain from using our name, and assumed they would do so, as they started using the name in 2007, as seen by the Wayback Machine web site.

I see they continue to use the name and as a result of their size, are shown on top of search sites like Google.  The USPTO  granted Moody’s a trademark for Credit Trends many years after we began usage

When applying for a trademark they were required to undergo a search to see if the name was being used for a similar purpose. For example, they could be granted a trademark for a Credit Trends dog food or funeral home but NOT for credit information or related business.

Obviously, both they and the US Patent and Trademark failed in this regard.

We are now asking the USPTO to have Moody’s trademark removed and that Moody’s stop using the name Credit Trends of Moody’s Credit Trends, and if not intend to file a lawsuit against Moody’s

 

Kenneth Hackel, CFA

President

Credit Trends

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June 30, 2020, Investment Review

A WING AND A PRAYER

Beginning Comment

If a (bat)wing triggered the health and financial crisis, it might take prayer to get us out, as a vaccine is no sure thing given flu shots have been around for 75 years, yet upwards of 60,000 Americans still die of it each year[1].  In the sang-froid world where CT Capital operates, invocation may follow the process, not be an integral aspect of it. Financial decisions must ground on the skills of firm executives and the attendant response of the buying public.

So, given we have a slim idea as to when an effective COVID vaccine might become available, we operate under the condition that normality will be restored. Since a timeline is a guessing game we do not play, we must heavily weight the natural ability of the firms in the portfolio absent governmental aid until the recovery ensues. The April thru mid-June period in which the account showed outperformance against both indexes for the year—after a healthy 2019— shows how quickly events can turn.

 

 

For entire Outlook and analysis, contact CT Capital LLC

 

 

[1] McKinsey writes the number of reported COVID deaths to be well underestimated. See https://www.mckinsey.com/business-functions/risk/our-insights/covid-19-implications-for-business?cid=other-eml-alt-mip-mck&hlkid=29f0e15f26f24962b86688c0f90319c7&hctky=2672065&hdpid=0a24bf6c-15ec-4e50-9709-381e0f5b160a

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CT CAPITAL LLC

 

Investment report Q1  2020

 

REVIEW AND OUTLOOK

“Faith in the future, out of the now”

–John Lennon

INTRODUCTION

Professionally, I have seen a very wide, often deep, and diverse set of financial circumstances in my almost half-century in this industry, both micro and macro. I have seen firms with seemingly high rates of stable growth decades into the future fail and firms emerge from bankruptcy into market leaders.

The current period ranks as the most difficult from a financially analytical perspective, as the protagonist was not borne out of a financial event and so needs to be solved by the non-financial sector.

The great lesson from the ranks of economic history, regardless of trigger, is the current dark period will end, yet the financial and related impacts will not be known for some time. And so there will be winners and large losers, commensurate with periods of large pricing volatility reflective of the new, higher cost of equity capital.

Firms with abundant credit resources will have an easier time to the other side while others will have a long road back, if at all.

One of the hallmarks of the rise in cost of equity capital is a small change in perception often leads to outsized changes in market value.

The current period requires a deep dive on credit, regardless of the time horizon of salvation. Many firms will, a result of breaking through negative covenants, be prohibited from various actions, including dividend payments, additional borrowings, acquisitions, or asset sales without a bank waiver.

Our assessment commences with the current liquidity profile, sources of potential capital with associated costs, expected loss of revenues and updated cash flow, legal commitments, potential asset sales, and as always, litigation. Smaller supplier firms might find relief at reasonable cost from their larger, stronger capitalized customers for part of their capital needs, both of a monetary and non-monetary nature. Others will look to non-banks or typical lending institutions, depending on their equity access.

Our strong credit firms should be able to capitalize on others weakness as Air Products did this past week in its $530M acquisition of 5 hydrogen plants having assured customer sales.

Where trans-ocean shipping is required, ports might be closed or on slowdown which too would require cash and efficient inventory and operational management.

Our holdings share the important strength of abundant calls on credit; a few have been wise having entered forward equity sales instituted when shares were considerably higher. Most firms have begun to utilize financial options as well as cuts to operations, share repurchases and dividends, capital spending, hiring and other measures. Crisis management teams are in full force.

We are hopeful firms will finally recognize the real cost of share buybacks and dividend payments and carefully weigh that cost when the crisis ends. As many firms that participated in such activities are now in dire need of cash.

We review the impact on employees and key suppliers and any potential fallout, including related alterations to the landscape such as cost and productivity. Contingency plans need to be established and clearly communicated to creditors and shareholders.

President Trump is the de-facto majority owner of firms like General Motors and others relying on federal aid, without which they could well fail. If the President “asks” such firms to switch production to a health-related item, they will feel enormous pressure to follow the directive. This too has a cost and must be considered in the analysis, including any lost market share and related impact going forward, vis-a-vis competitors.

We must not lose sight of the crisis moderating; of understanding where the  firms stand on the credit front (liquidity profile, including that of customers and suppliers) and if changed, the new level and sourcing of sales, supply chain, divisional count, plans for implementation of improved and reliable technologies including robotics (don’t get viruses) and of understanding the firm’s plans going forward, including debt reduction, marketing strategy, margins for segments under expected growth rates, asset impairments, change to valuation allowance,  taxes, employees working in new locations (i.e. home) and updated costs related to insurance, leases, travel, closings, pension, health, and productivity.

We believe our cost of capital model covers most to all risk elements our firms may confront, from sovereign to insurance, litigation, natural disasters, or elsewhere. While our model includes risk of natural disasters, such as the penalty we place on Japan and elsewhere, it did not previously include health related risk.

That is why we scoff at recent comments “the cost of capital is low enough,” as they are evidently looking only at the cost of debt, not equity which is based on the risk to the free cash flows.

We feel we can never repeat enough the vast preponderance of a firm’s estimate of fair value is composed of their free cash flows many years out, even should the next few prove disappointing. It is why stocks rise over time, as investors typically overweight nearby cash flows.

In fact, for a hypothetical firm currently selling at a free cash flow multiple (that maximum cash that can be distributed each year to the equity owners without impairing the firm’s optimal future rate of growth) of 15 or a free cash yield of 6.7%, and whose real free cash flows are expected to grow by 0% per share for the coming 3 years, then 5%, 87% of the current value of the firm is composed of those cash flows 5 years and out. Not next quarter or even the next 4 years.

We believe our firms have the ability to ride out a period of deep stress (we own no energy, airlines or firms currently requiring federal assistance) and while estimates of fair value are now lower for all firms in the portfolio given we have cut expected growth rates across the board and raised cost of equity, we also believe there are no firms in the portfolio that could be bought out for cash at a lower price than were at the end of 2019. Certain stock transactions (such as if xxxx bought xxxxx) could make sense near that valuation. Next line omitted from general distribution edxition

So, even though our invested firms generate, over the normal cycle, more cash per investment dollar than benchmark commensurate with higher interest rate coverage, more stable and consistent key metrics such as stronger calls on credit, and lower cost of capital, their investment performance still suffered.

Banks are facing a crucial period, given the term structure of interest rates and negative interest rates around the world. That backdrop and required reserves alters the landscape for the sector, especially when pricing loans and deposits. Treasury help will continue to be essential in keeping the system sound, liquid and dependable.

ANALYSIS

And so, we must view the current dislocations–operating and financial, micro to macro, capitalistic states to communist—as ranking near the top distress points in financial market history.

The analytical process for us begins, at the operating level, at the collection of receivables, and the level of uncertainty associated therewith. Are there likely credit losses? Or are collections merely slower?  What is the likelihood and magnitude of orders slowing both during and post-crisis? To what extent can expenses be slashed or eliminated? What is the degree of tax offsets including those resulting out of the new stimulus law; will there be follow-up legislation including reimplementation of the tax-loss carryback? To what extent can the firm operate at all, and to what extent are clients impacted with the approximate shape of the snap-back period?

Credit analysis must be tailored to both the individual firm and its competition. The stronger possess the ability to raise external financing at levels that allow value-adding deals regardless of the level of stress.

It must also include means to boost service or other income, cost of hedging and counterparty risk; potential renegotiations leading to cost savings such as leases; strength of banking relations and other such relationships; yield curve impact; customer and supplier impact, impact of stock options (as a provider of funds and tax implications) ability to retain executives, regulatory reporting and requirements, and updated credit rating.

Other areas of inspection include impairment to goodwill, tax valuation allowance and impairment of equity method investments.

Then there are analysis, estimates, and possibilities related to additional uncertainty related to prospective Fed and Congressional actions, consumer response, insurance costs, tax (many factors here), employee benefit costs related to pension and other benefits and perks, executive compensation, possibilities of timely acquisitions and joint ventures, cost sharing, sovereign risk and, lest we forget, the ongoing trade issues with China and Europe, US election cycle, and so on.

Cash flow hedges may be moved to earnings though may still be included in AOCI.

We have, as would be expected, re-normalized rates of growth of 2020 and 2021 sales and free cash flow—hence return on capital. Many firms will not generate free cash flows this and possibly next year, while quite a few will be within normal bounds followed by large bounce-backs as the health issue is under control.

We feel our methodologies are appropriate given how the world economies and especially our holdings were operating prior to the health crisis and prospects for growth in newer technologies, notably 5G.

Even considering large cuts to our 2020 and 2021 outlook, we conclude our portfolio is worth holding, while if the health issue is resolved or moderates prior to that time, our holdings would see very large rises in financial metrics and coincident expansion in valuation multiples within short duration.

THE OPTIMAL COURSE OF ACTION

I have seen corporate executive officers take advantage of past crises in making strong value-adding deals while others acted in haste making acquisitions of declining businesses; some get “gun shy” or make other poor cash decisions such as failure to recognize a change in marketplace.

Well-managed firms with a history of making appropriate use of capital and strongly defined acquisition criteria will again benefit when the current period subsides.

Survivability and debt negotiations are the chief concern for firms facing s cash commitments and should lead to a large rise in default rate. Many firms rated BBB- will now fall into junk territory forcing certain investors to sell (or not buy) their securities placing additional pressure on their ability to finance the business at a reasonable cost.  In my almost 50 years in this business, a firm owned on behalf of clients has never filed under the laws of protection.

Many firms, in preparation for, and in reaction to the spike in yields, are drawing complete lines while others are preparing filings—-requests for new CUSIPS have surged. These additional incremental costs are significant on top of the revenue issue and should prod investors away from riskier assets.

Pension liabilities will soar for the over half of the S&P 500 firms which, over the past decade, have been severely underfunding (and more so in relation to that reported under GAAP) their liabilities in hopes of greater investment returns. Several of our firms have been impacted, but not to the degree that would cause us to alter those position given their long-term cash flow stability. Congressional offsets could be of help here and is being discussed for multi-employer and single employer plans.

Even with the current barrage of news, our deep scrub analysis will be of enormous help when the current health issue is, if not completely resolved, at least lowered. We expect many of our holdings to make use of their deep pool of resources to acquire assets and world-class talent, which will lead their shares to new high ground over time.

The stark reality is whoever thinks “Corona” is a six month or even a 2-year event is kidding themselves. There is currently much work to be done by our Government, our corporations, and our citizenry. Expenses will need to be realigned, having profound impact on many sectors; a few will benefit as firms move more to virtual, robotics, lower lease expense, and significant costs re-optimized, including right-sizing of facilities, labor, and supply chain. Share buybacks and dividend growth will slow or stop, boosting credit.

All firms in our universe have seen their cost of equity capital raised by 15-40 basis points minimum. Over time, our expectation is the reduction in expected free cash flows will aid in reversing said rise.

Aside from credit, the main current issue facing valuation is the new long-term expected rate of growth of free cash flows, not the size of the of cut to the current year’s adjusted and normalized free cash flows. We already pointed out the preponderance of current valuation is due to cash flow years out, meaning the ability of the firm to provide excellent product and service will see them prosper.

We do not need to see real return on capital back to where it was in 2019 for a restoration of values if there is belief stability of prospective metrics will rise. In life and investing, there is great value in certainty.

As supply chains are enhanced, including moving out of high-risk zones (a process underway), and which may even take years, cost of capital will fall as stability metrics improve.

As firms begin to report and hold their yearly analyst meetings there will be intense scrutiny on the cash burn for the current and upcoming periods, as well as changes to operations, investment and financing decisions.

Our cost analysis includes an “invisible handshake” firms make with employees that, if possible, their jobs are safe, permitting a restoration of revenues and avoid re-training expense when the smoke clears.

Lastly, we add, is our strong desire for legislators to be better prepared for the next health scare or crisis, whenever it may occur. This includes everything from sanitizers to cyber. Of current utmost importance is the capability of the U.S. to produce the active pharmaceutical ingredients for life-saving drugs currently relied on from China and India.[1]

CONCLUSION

Stocks have always risen to newer high ground despite wars, nuclear crisis, assassinations, oil embargos, catastrophic financial crises and deep economic depression.

We conclude the optimal option is to stay with the program, even if we see this short-term pain lasting over a year. In the meantime, there isn’t a medical facility of higher learning or pharmaceutical company in the world not looking for both a treatment and vaccine.

In this report we detailed those many areas of importance central to our analysis. We are confident this will lead to a restoration of values, and then some.

For reasons discussed, will trust you will then view the current value of your account as an anomaly, to be restored as it was following March 2009. Our firms are world-leaders fully capable of generating excellent excess cash over the normal cycle under prudent credit, allowing them to withstand financial stress while providing the fodder to take advantage of value-adding opportunities.

 

Kenneth S. Hackel, CFA

Eli C. Hackel, CFA

 

[1] Sen. Marsha Blackburn of Tennessee has introduced such a measure.

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COMMENT ON THE CORONAVIRUS
While some well-known large fund managers and medical experts have commented the coronavirus will pass, as does the flu, there will undoubtedly be a long-term impact to corporate decision-making, future free cash generation, credit, and cost of capital. This new deadly virus comes not long after SARS, and so the second important health risk out of China must be weighed, especially as expatriate firms typically set up factories in low cost areas where health outbreaks are more likely.

While some sectors are particularly sensitive to China, almost every large firm will feel some effect. To ignore health-related risks is to understate true cost of capital.

As you know, our portfolio accentuates structurally strong firms seeing normalized real growth in free cash flows, coincident with an adjusted return on capital safely above cost. And so, a year’s shortfall in the otherwise expected free cash flows has a lower than benchmark impact to its long-term current fair value.

Indeed, for the average firm in our portfolio, about 80% of its current fair value is comprised of free cash flows 6 years and out, meaning consistency is a central element of our philosophy, with cash flows more evenly spread. A year’s shortfall in the current year should have about a 2.2% (firm dependent) weight to share price. If the free cash flow were to be recouped, so would market valuation. Shareholders, we see time and time again, exaggerate shortfalls, including those firms with growth in key metrics.
Tesla, to cite a contrary example, due to its higher cost of equity alongside more uncertain cash flows further in time, should see a larger drop in its share valuation if it were to underachieve.
We so prefer the “bird in the hand.”

There are six impactful financial areas of note regarding the coronavirus:

1. Current supply chain-Several large Chinese cities are in effect, shut down, with most large firms haven taken actions to curtail or shutter units. Ports are reporting lower volumes.

Should the virus continue to spread, the effect on both cash flow and credit would certainly be impacted should firms not be able to shift resources. Most firms in the portfolio have, to the extent possible, been diversifying out of China. Our technology related firms, due to the trade conflict, have seen a China “hit” and, off the new base, have been forecasting real growth going forward, being leading-edge on the precipice of 5G. This latest issue could cause additional short-term pressure for the sector given constraints on current supply chain.

2. Future supply chain-The coronavirus will undoubtedly force firms to step up their diversification programs, including customers and supply chain, impacting short-term expense yet reducing longer-term risk. Labor, component and assembly, transportation, pension, tax, cost of hedging, and insurance will feel the brunt. Each firm must be individually studied as to cost and sales relations.
3. Valuation multiple-The virus is impacting, for reasons cited, valuation multiples. The contraction influences firm credit, depending on need to raise capital to tax and cash flow implications.

4. Impact to revenue-This is complex depending on whether sales are customer direct, intermediate or postponed. To the extent consumers reign in current purchasing, sales, employment, and capital spending would be impacted.

5. Impact to credit-Should the virus linger, Boards would halt their stock repurchase programs and perhaps draw on existing lines. Cost of capital would thusly be affected.
6. Increase in trade friction with China-It is conceivable China could claim the virus has passed, yet the US may want a prophylactic period or further proof. This could alienate the Chinese who might then threaten to raise tariffs or refuse to buy goods promised under the phase 1 deal. Firms are also getting tired of Chinese threats.

So, given the above what are we doing?

We are monitoring at this stage, yet expect our firms, regardless of their sector, historical results or prospective expectations, to take measures in furtherance of diversity of the various layers out of China.
We have long recognized the China risk and have so written in the past.
We hope the Congress will practice the “shoe on the other foot” approach, and like China, support the nation’s leading-edge industries. As plainly evidenced, China provides wide support to the likes of Huawei, and the US must do likewise.

Kenneth Hackel, CFA
Eli Hackel, CFA

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REVIEW AND OUTLOOK

2019 was a solid year (+682 vs Russell 1000 (TR) and +188 vs S&P 500) despite only one holding (the 15^th) of the top 15 most heavily weighted firms in the S&P 500.  For Q4, the 32-basis point gain vs. the S&P going into December’s “fool the client games” flipped while still outperforming the harder to manipulate Russell 1000 Value (TR) index.

Moving into the new decade, we remain confident as holdings sell at a median 14.7x normalized and adjusted free cash flow with 14.7% adjusted return on capital and 7.2% cost of equity capital versus a latter of 8.1% for the S&P 500. Our firms are of stronger credits, possess greater stability in key metrics and, in general, are seeing growth in in adjusted free cash flows in excess of benchmarks. Such are the characteristics that bring superior long-term financial management.

 

FOR THE FULL REPORT CONTACT CT CAPITAL LLC-—INSTITUTIONAL INVESTORS

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……………

Yet, our accounts are of higher quality than benchmarks.

The firms enjoy more consistent key metrics, have a safer spread between cost of, and return on capital, stronger credit, and higher return on equity and economic profit. Each of these metrics is formulated via important adjustments to the published financial statements. In our last report, for example, we illustrated the difference between our estimate of free cash flow and that used by the leading data service provider, FactSet. In prior reports we showed the adjustments to arrive at cost of equity.

It has indeed been an unusual economic expansion, yet as we continue this stretch of worldwide slowdown, trade disputes and US political cycle, we should continue to find investors gravitate toward firms offering superior value, judiciously analyzed, both qualitatively and quantitatively.

The linchpin going forward will be these firm’s ability to deploy their excess cash and credit in a manner consistent with past practice, accounting for but certainly not limited to a change in tax policy (foreign or domestic), supply chain or factors outside the sphere of normal business practice.

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….from our latest report to clients

 

That the account is outperforming both S&P 500(TR) and Russell 1000 Value (TR) indexes this year is merely in line with historical trend given the alternation in risk landscape and stage in cycle. Employment of an accurate discount rate guides us to firms in the portfolio as their valuations become faulty due to analysts’ overstatement of entirety of risk profiles.

As risk levels to free cash flows ascend our accounts should continue this outperformance, though any given quarter is subject to the many externalities.  As the period elongates, outperformance should broaden vs. benchmarks as a greater cross-section of investors adjust for previously unaccounted-for risks, including that of outright financial failure.

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Didn’t realize how many of you enjoyed our previous works on this site. Just read comments, some of which were years old.

 

Unfortunately, more recent works are for the benefit of our research clients, all of whom are very high NW or institutional in nature.

 

We will, from time to time, distill some of our analysis a week or two after client receipt, and post here.

 

Sorry haven’t kept this up-to date; suggest you look at my twitter account (@credittrends), though there I post on a variety of topics, many baseball related as well as finance—as you will see I am a big Yankee fan

 

Lastly, I would urge you read my last book, “Security Valuation and Risk Analysis,” after which I am sure you will rarely listen to analysts or other gang of idiots you see on CNBC. They have NO idea of the scores of items behind each line entry in the published financial statements. And in most cases, neither do their CFO’s

 

KSH

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The following is but a small portion of that sent to clients

 

What conducts of equity direction are observable, logical, and have shown to be determinants of valuation?

Table not shown here

We know though the reporting season has just begun (98 firms reporting) a greater number (76) have ratcheted down their expectations for the coming year.

We know sovereign and trade risks have increased worldwide, driven by the China-US dispute and stiff tariffs, as well as US-Iranian sanctions.

We know the upcoming election cycle given prevalence of political risks could well bring tangible change, some of which can be expected to impact firms cash flows, return on capital as well as other determinants of valuation. Sections of the recent Tax Reform Act could be in jeopardy, and consumer confidence could swoon if impeachment talk gains momentum or economic activity stalls as rates continue its rise.

It is with this backdrop we focus the bulk of this report on risk.

We outline herein why, therefore, account performance has been acceptable though trailing S&P 500, specifically why we believe the portfolio is “set up” to minimize risks of the back-end of the cycle while our firms cash flow generating assets should allow them to continue their histories of solid credit and additions to capital geared to prospective free cash flow, while giving space to flexibility many concerns would need to bypass. No firm wants a credit downgrade under a slowing economy.

Many of the outperforming stocks in the benchmarks this year have been older firms which have primed the earnings pump through reduced pension expense yet will now need to make large cash infusions to their assets, having been beneficiaries of such reduced funding the past three years, boosting reported cash from operations and engaging in large share repurchases. Pension debt and its annual cash outflow effects 326 firms in the S&P 500, or slightly over 65%, so this large liability is certainly nothing to sneer at.

We are sitting in the “catbird’s seat” with these holdings (see highlighted box), a time when equity prices in general could be challenged.

Add to that multi-employer debt (this liability is excluded from balance sheet listing) and overseas pension liabilities, State’s cumulative $1.6 trillion deficit, and the $74 per employee (increases are certainty with new indexing) charge to PBGC, and one can’t help but adjust potential cash flows and credit valuation multiples downward if markets stagnate.

Of general consequence as impacts the portfolio remains the full brunt of the Tax Reform Act, where our holdings will almost certainly see incrementally favorable benefits versus the ever-so popular FANG companies. That investors have in so many instances failed to properly examine and account for future (including compounding of) tax benefits is unremarkable given the proclivity for investors to react in arrears based on the news of the day.

The new GILTI ensures a residual U.S. tax of at least 10.5% when the foreign effective tax rate is less than 13.125% and with the uptake to 100% bonus depreciation and territorial approach the legislation favors the majority of the portfolio, especially with their 21% Fed rate versus the FANGS lowly four-year average cash rate of 12.7%.

Let us not fail to mention the FANG’s are mainly one product consumer tech firms; a major obstacle to our investment decision approval process.

The EC is resolute these mammoth tech-driven firms pay their fair share as opposed to a “negotiated rate.” Ireland and Luxenberg will not enjoy their current tax advantage indefinitely, as seen with Apple having to recently cough up $14.3B.

The GILTI, after exemptions and credits will hit fewer firms than originally thought, though the Treasury and IRS are still issuing clarifications. Undoubtedly, there be an offset to many firms’ previous cash flow expectations and rate of growth, especially with the final chapter not yet written.

Analysts refusing to accept the new tax realities under the guise of a bull market and economic expansion are being foolish.

Of significance, should the 10-year risk-free rate rise another 50 basis points or so we will likely see more leveraged entities having significant debt due within the upcoming three years or reliant levered customers/suppliers see their valuations react rather suddenly. Should such take place, we reason investors will look towards the more consistent firms with wide financial flexibility, including those such gems contained in our portfolio.

IN ORDER TO READ THE REST OF THE REPORT AND OTHERS, YOU MUST BE A CT CAPITAL CLIENT

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PLEASE BE ADVISED THE FULL REVIEW IS SENT TO CT CAPITAL CLIENTS INCLUDES IN DEPTH FIRM REVIEW WITH ADJUSTMENTS TO THE PUBLISHED FINANCIAL STATEMENTS

 

The account continued to outpace the Russell 1000 (TR) Value by a very wide margin over the last 5 years, while the so-called tech-based FANG stocks have again propelled the S&P 500 this quarter. The long-term very high correlation between the S&P 500 and Russell Value broke apart in 2015. One would certainly expect they will again converge at which time our performance can be expected to surpass that benchmark as well.

For the portfolio, the Tax Reform Reconciliation Act fundamentally altered the way multi-nationals are taxed, and yet we have found many have not altered their international financial structures which were set to take advantage of a now antiquated tax system. Our firms stand in a relatively stronger position from which the account should benefit in the years ahead.

A US shareholder of one or more controlled foreign corporations must include in gross income its GILTI (Global Intangible Low-Taxed Income). This rule generally subjects a US shareholder to tax on the combined net income of its controlled foreign corporations that is not otherwise taxed in the United States, thus giving many of our holdings a nice domestic advantage, especially when combined with the new 21% statutory rate vis-a vis foreign entities so subject. Much of this will be felt as the years roll by.

Many companies will find they will be subject to the base erosion (BEAT) tax it did not expect.

COMMENTARY

Consumer tech eventually meets its match and for Apple it may come about from sovereign interference or plain old competition[1] as 5G comes to pass next year or perhaps a residue of its litigation with Qualcomm. As shown in Table 1 Apple’s economic profits as a percentage its market value, using proprietary CT Capital worksheets, has declined the past two years, its first consecutive such decline over the past decade. Economic profits, not return on capital, is the appropriate benchmark for Apple due to declining equity, assets, plant and equipment. Should this trend continue, its shares will very likely drop as well.

[1] See https://www.cnet.com/reviews/xiaomi-mi-8/preview/

Many companies will find they will be subject to the base erosion (BEAT) tax it did not expect.

In the 1990’s investors also drove technology shares to unfathomable heights. Yet, no sector undergoes market share alternations more rapidly, with each generation seeing firms thought bullet-proof fold. Anyone know where I can buy Kodak film? A Wang word processor, or a Magnavox TV? Nokia was thought invincible not too long ago as were Lehman and Bear Stearns. We are not suggesting Apple or Google will meet similar fate, yet they too will meet their match.

Restrictive trade policies and actions to be established under CFIUS could bear on free cash flows, employment, and government policy. There is no guessing the extent at this point; sensitivity analysis helps estimate any potential impact on existing and potential investment related to supply chain, segment sales (cash flows) and other expense, including asset relocation if necessary. The discount rate could be impacted as well if expected free cash flows are to become increasingly uncertain.

To be sure, the crystallization of the BEAT (base erosion tax) provides additional expense to non-US firms, in a way forcing Europe’s hand, yet it is prudent not to over-react at this point.

AN UNDENIABLE LONG-TERM TREND GOING OUR WAY DESPITE AMAZON

When those FANG investors move on we believe many will indeed gravitate, despite this week’s Amazon announcement, toward our investments in CVS and Walgreens, which have all the characteristic of becoming the next McDonalds or Starbucks.

Upon Amazon’s announcement it would acquire Pillpack, a firm which has been for sale quite a while and has slightly more than $100M in sales (vs CVS almost $200B), the combined market values of CVS and Walgreens market values fell $12B. We have seen Amazon scares too many times to count and remain doubtful they will be able to make large inroads against the physical locations.

The future of health care is “closeness to the consumer” —CVS and Walgreens employ over 600,000 with over 20,000 locations. Amazon has zero locations. Amazon does not enjoy similar advantage in health they have in general retail, such as pricing, delivery, and technology.

Importantly, consumer health hubs—dental to urgent care—is taxiing on the runway and a space where they needn’t worry about Amazon, and both CVS and Walgreens are active and gearing. CVS currently has over 1100 such clinics in 33 states while it is estimated both companies control between 50%-75% of the drugstore market.[1]

Example: Clinics offer a quick means to combat the spread of disease or illness as was seen this month in Ohio where an outbreak of hepatitis A took place. CVS’ MinuteClinics offered Hepatitis A Vaccines statewide following the outbreak of the virus.

And with its expected merger with Aetna, we are confident CVS is primed to become a large winner for the portfolio, ensuring superior return on capital and economic profits for years. Aetna’s insurance is a product Amazon does not offer, bringing additional large cash flows into the firm.

CVS and Walgreens have vast experience in best practices—including real estate management, billing, Medicaid and psychological services— making this indisputable movement of health hubs ferrying considerably lower risk with strong prospective growth. While the hubs could very well be sad news for hospitals and even for Amazon’s health unit, CVS and Walgreen’s are well-primed to benefit while selling at high normalized expected cash yields.

The implications of the Tax Reform and Reconciliation Act will also prove a catalyst to these firms—CVS’ cash rate of 38.6% and Walgreen 26.5%. Amazon is facing large tax bills in Europe. As written last quarter, the compounded effect of the Budget Act has yet to be fully digested by investors, and especially for those firms which make value-adding decisions with regard to said cash. Real return on capital and economic profit/market value is quite likely to remain at least 4 percentage points above their weighted average cost of capital for all our healthcare holdings.

INVESTORS MOST OFTEN EXAGGERATE SINGLE PERIOD IMPACT ON FAIR VALUE

Large share price movements following earnings announcements are typical as investors overstate a single period’s importance to fair value. Investors and firm executives who extrapolate recent events are quite prone to error.

And so, earnings reflex often reverses as events normalize for firms with strong market penetration and growing markets. A shortfall to a single quarter effects fair value to only a minor degree, as a firm is worth the present value of the entirety of its free cash flows plus a terminal value. For instance, at a 7.5% discount rate and free cash flow growth of 15% per year for 10 years, moderating to 2% thereafter, the current year free cash flows can often constitute just 2.6% of its total fair value[2]. For lower initial growth the impact is even smaller. So, when we see a holding’s market value react inappropriately, we exercise patience, all else equal. Such pessimism is most often unwarranted and why shares in fact shrug off the short-term nonsense given sufficient time.

This brings us to Fluor, which dropped this quarter on its announcement. As you know we prefer to write of firms which did not meet their normalized metrics as the winners speak for themselves.

Fluor, a construction and engineering firm, which could have as many as a thousand jobs going in various stages, mis-bid a gas-fired project, the consequence being a write-off and always-present possibility of additional cash outlays. Such action does not reflect well on their bidding teams as fixed price contracts always carry risk. Over the decades such “wins” too often have resulted in losses, yet for shareholders it has paid to stick around.  Other times a single job can sink a company, as was the case with Morrison-Knudson due to its then subway manufacturing division.

Meanwhile, Fluor’s backlog remains satisfactory though subject to many factors, including energy prices and political events. The firm is supported by strong credit and liquidity of $7.5B. As with many firms, they erred in its use of capital, re: share repurchases, for which we penalized its cost of equity.

Given firms like Fluor have a strong tendency towards normality, in this case a rather consistent normalized 15.65% (Table 1) adjusted return on equity, we remain with the position.

 

Figure 1-Fluor Adjusted Return on Equity-NOT SHOWN, SENT TO CLIENTS DUE TO PROPRIETARY NATURE

IMPORTANT DISTINCTION BETWEEN EQUITY AND FIXED INCOME INVESTING

As the default rate on high-yield instruments drops, yield spreads collapse, and bonds priced near bankruptcy offer superior returns relative to investment grade. Approaching a default rate nears zero, a firm’s credit rating—for bond investors—become less weighty and the appropriate fixed-income investment strategy is to allocate a higher percentage of the portfolio within firms paying the highest rates of interest. For this reason, CCC rated firms have outperformed investment grades over the recent past.

The same investing logic does not apply to investors in equities.

Yet, have those investors throwing a record volume of capital into lower quality debt again laid the seeds for a credit “event”? Leverage loans (LIBOR 125+) are now greater than the high yield market, exceeding $1.2 trillion according to Fitch, and while maturities have in many cases been stretched out, investors look over the hill in decision-making.

Because funds for acquisitions are abundant and yield spreads tight, we have become increasingly mistrustful of those large-scale technology deals [3] . We would not touch AT&T with a ten-foot pole. And unfortunately, we have seen credit agencies giving acquirors abundant headroom and become too rating-lenient, abundantly trustful of management puff instead of penalizing for the credit build.

As interest rates rise the great corporate debt build will begin to have consequence as rollover time nears.  Over the past decade, according to McKinsey, corporate debt issuance has nearly equaled the rise in government debt.

And furthermore, as refinancing’s become due for roll, it would not be unusual for key metrics to be below peak.

The Tax Reform and Reconciliation Act limits the deduction of interest expense in the US to the sum of business interest income plus 30-percent of adjustable taxable income. Many firms who may now seem far away from the ceiling will certainly run thru it, having an absolute impact on valuation.

Higher rates of interest are more easily tolerated for firms with high return on capital (or economic profit), while for other firms becomes more difficult to grow or even maintain its spread with cost of capital.

Importantly, with interest rates moving up piecemeal, our firms enjoy strong credit rankings by our higher standards. Investees have little to zero exposure to floating rates and about 13% of their debt due the coming 3 years. They enjoy strong flexibility with more than adequate credit facilities.

VALUATIONS– NEVER EVALUATE ON A SINGLE METRIC

When comedian Henny Youngman’s was asked: How’s your wife? He responded, “Compared to what?” The same applies to valuations.

Someone should tell analysts at Factset—a firm I was an original client and helped one of the co-founders set up some proprietary financial software—as well as investors and other data providers, single metrics should never be viewed in isolation. Valuations (Figure 2) must be viewed relative to inflation, credit, prospects, consistency of metrics, lawsuits, taxation, etc. and not relative to itself as a measure of value. What good is a free cash flow yield of 12% (8 multiple) if inflation is 15%?

 

Figure 2 Valuations Must be Viewed Relative to Other Metrics-FIGURE NOT SHOWN

Same is true advice for the St. Louis Fed researcher in making a case between recession and unemployment. High employment is not, in and it itself, a motive for recession but may be a function of imbalances (inventory), excesses (dot -com) or government action (Vietnam War). In 2008, the lower unemployment rate was a function of large scale hiring in real estate and related sectors.

CONCLUSION

While the high-yield default rate is expected to stay low for the time being allowing valuation multiples to remain lofty, sector and firm-specific valuations can be expected to undergo platonic shifts due to alterations in risk—from trade, location of suppliers and cusitmers, to credit— topics we believe CT Capital has a large competitive advantage.

We do not pretend to have a crystal ball, only our financial statement adjustments and definitions bear a closer reflection of economic reality and have worked well over multiple cycles.

 

Kenneth S. Hackel, CFA

Eli C. Hackel, CFA

[1] http://fortune.com/2017/12/04/why-did-cvs-tical buy-aetna/

[2] Assumes typical CT Capital credit, return on capital and economic profit and cost of capital.

[3] AT&T will have over $180B in debt post its Time Warner acquisition.

 

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Robust asset growth in passive portfolios is ascribed to active managers’ inability to earn higher post-fee returns. We have long attributed this to benchmark composition which has overcome the placement of valuation in the make-up of the benchmarks: simply, large firms with strong market shares whose products and services drive superiority of credit, cash flow, and return on capital compared to the investment universe at large. Under similar and reasonable logic, the CT Capital portfolio, whose firms are of higher credit, generate stronger (operating and free) cash flows per investment dollar, with higher return on capital than the benchmarks, should consequently outpace this hurdle rate over the cycle

The growth in “smart beta” products, which has so captured investor and consultant imagination deploys naively constructed metrics, is substantially inferior to the CT Capital worksheets, and would never be considered by credit agencies, bankers, and potential financial acquirers as compelling proof of worth or ability to satisfy claims

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It has been estimated that about 90% of investment advisers were under performing their benchmarks going into the final month of the year. To make up lost ground, the smaller stocks would be easiest to push up in price. As evidenced in the following table, there was a perfect positive reverse correlation between December’s returns thru December 30 and index size.

 

	December Games?
Index	Mkt Cap-Median	Return
S&P 500 (TR)	$18.8B	0.79%
S&P 500 (TR) Top 10	$313B	-0.57%
S&P 500(TR) Top 25	$251B	0.27%
Russell 1000	$8.1B	1.73%
Russell 2000	$.7B	3.56%

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The clear rejection by the Board of AstraZeneca to Pfizer may not necessarily mean a permanent end to a deal. This reports reveals what the Board needs to hear and the possibility of such taking place.

 

This report available to consulting clients of CT Capital LLC. Contact kenhackel@ctcapllc.com or gailtrokie@ctcapllc.com for information

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