Are Security Analysts Over-Promising Again?
I see the head economist at Goldman Sachs (GS) is now forecasting the US economy will either be “fairly bad” or “very bad.” If his forecast proves accurate, what does that say about equity investors in general, who have carried valuations and equity benchmarks to new yearly highs? Does it also tell you Goldman’s economists and research teams are not on speaking terms?
The seeming financial markets’ inconsistencies are only reinforced by bond yields, which across the risk curve have fallen to new lower yields, with spreads also indicative of a robust and healthy corporate high yield sector. Hard to believe the 2-year swap spread currently stands at 16.8 basis points from over 50 in May—this has reduced cost of capital in CT Capital’s models and aided equity valuations, although it is but one metric of 60+.
Perhaps the push toward equities is made more understandable from viewing a chart put out by McKinsey & Co. in its July 2010 quarterly letter. The illustration reveals equity analysts have been, on average, about 100% too high in their earnings forecasts—with expectations of 12% per year versus the 6% that actually materialized.
The illustration takes on increasing significance when viewed in light of corporate cash flow adjusted for balance sheet changes, which has grown less than 4% for the S&P Industrials over the past year. Free cash flow (excluding such adjustments) rose 15.2% due primarily to increased collections on higher revenues, working capital management, other cost cutting (including capex, supply chain, labor) and input savings; but, in general, many firms are now reversing course and are taking on growth projects, even though expense control is still very much in force. The latter will be interesting to monitor in light of the recent run in commodity prices. If input pressure continues we will see it affect valuations and cost of capital, which could prove a double whammy if Goldman’s forecast becomes reality. We will see if we pick up greater instability in cost of sales ratios in the quarters ahead.
For slow, stable enterprises, stock buybacks are squandering funds; not so for faster growers who, in general, are acting smarter and redeploying cash towards value-adding acquisitions and internal needs without exposing the firm to greater credit risk.
When adjusting reported cash flow from operating activities for normalized working capital levels, and with revenue growth modest (although stability of revenues has improved which aids cost of capital), analysts must be careful, as history has shown they have over-promised and under-delivered.
While CT Capital’s models conclude equities are undervalued, it is also seeing many securities vastly overpriced—nothing more than lottery tickets of perhaps a potential buyout or the continuation of a poor dividend policy. This latter group is nothing more than dividend “traps”: firms which, due to today’s lower term structure of interest rates, are currently disbursing unsustainable payouts.
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Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.
