Credit Trends

Honeywell (HON) announced a change to its method of pension accounting whereby it will reflect changes in market value each year instead of the smoothing them, which helped show a healthier plan when market values were declining for Honeywell. Now that market values are rising, Honeywell is desirous of changing its methodology.  The company then revised its earlier results in conformity with the changes.

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Ken Hackel, president of institutional equity manager, CT Capital, and author of Security Valuation and Risk Analysis (McGraw-Hill, 2010), warned about six months ago, of the impending pension liability. Now, as expected, firms with large defined benefit plans are fessing up to the power of the discount rate on the ultimate liability, which is now resulting in stepped-up contributions. Hackel estimates that for many firms, with 10-year Treasury bonds at 2.5%, a further 1% reduction in current yields could very well have the same impact as a 20% reduction in the estimated long-term investment return assumption. When Kenneth first started writing of the liability, a 1% reduction was roughly equivalent to a 15% decline.

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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?

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Because I will be busy with final page proofs on the text, I will be unable to edit the full report on HPQ this week.

The analysis suggests, however, that selling in HPQ has been overdone, given its free cash flow, growth rate in cash flows (from operating activities and free), cost of capital (of 8.1%), return on invested capital, and stability measures. Adjustments were made which lowered reported operating cash flows and increased balance sheet debt.

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I’ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009. 

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It’s a hot topic these days.

What are companies to do with the great cash build? Good question—as the data strongly suggests those balances are only going to get larger. The data also suggests it will do so at a more leisurely pace.

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This week, a prominent financial journalist was reporting on the cash flows of a well-known company, accentuating its strength and growth.

The reporter detailed the analysis of this public company by a firm which “specializes” in cash flow-based security analysis; however, as I looked into their analysis (which I have a hunch is a computer generated number as they are a small firm, yet issue cash flow reports on every S&P segment), I discovered they neglected the effect of lease obligations, which for this company, was substantial. The company does produce healthy and consistent cash flows, and its credit strength allows them to sign large capital leases which, under Generally Accepted Accounting Standards (GAAP), appear on the balance sheet, as opposed to operating leases, which do not, but should. Thus, capital leases result in more conservative reporting as they are included in normal debt and leverage ratios. This is not always the case with operating leases, similar to other post-retirement benefits, like health care, which are not normally included on the balance sheet and are not pre-funded.

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The table at the bottom affirms the relationship between stock price valuations and cost of capital. While the free cash flow multiple is also clearly important and carries significant value, and is a far superior indicator than the P/E multiple, it is change in risk that leads the equity market’s direction. Most pundits would agree, as last validated March, 2009. Keep in mind the free cash flow of the firm is the income to the investor. The same cannot be said with earnings!

During bull markets expansion in multiple valuations is commensurate with like growth in free cash flows, pushing those multiples even higher.

During bear markets, even though firms are more managed for risk, the cost of capital rises, as investors demand additional compensation for the increase in exposures. This comes even though valuation multiples are being suppressed.

As the table shows, during June, 1987 (which doesn’t seem that long ago to me) I was warning of impending risk, and finally shortly before the October crash, was quoted in the New York Times: “ The bull market is dead , it’s over.”  This quote was repeated the following day.

Several months after the crash, as many firms needlessly fell to ridiculous levels, four stocks in my clients portfolios were bought out. Because of that, I was featured in an Inside Wall Street column in Business Week titled “A Divining Rod for Deal Stocks is Striking Gold” and from that article, correctly predicted no less than 4 additional companies than were eventually bought out. It was just a matter of cash flow, risk and valuation. Nothing, as Warren Buffet would surely note, has changed in how the valuation of financial securities should be performed today. There are new instruments, to be sure, but how one goes about such valuation of risk and reward, will barely change.

Over the past decade and a half ( except for the early 2000s) leading up to 2007, as the table notes, risk remained reasonable for the S&P and free cash flows were growing. At that end point, our metrics clearly picked up the change, a long time prior to the world-wide financial and credit meltdown.

To see our worksheet, please pre-order “Security Valuation and Risk Analysis.” at any online bookstore.

As for where we stand now, and what investors can reasonably expect, the table, our other data and history, point to sub-par (below 8%), yet positive returns over the coming year. The cost of capital, at 9.1% is sufficiently high such that any increase in risk would surely result in a magnified effect on stocks.

True, the free cash flow multiple is in the bottom quartile of its historic range, but the cost of capital is in the top half. This combination of higher risk and lower valuation is almost always a recipe for out-sized volatility. Normally it takes years to see the type of reduction in risk necessary for a prolonged expansion. If that seems excessive, recall stocks have declined over the past decade. This, however, should not preclude investors being exposed to stocks. With 10-year Treasury’s under 3%, investments in firms with a clear spread between their cost of capital and their return on that capital should bring superior returns to their stockholders, given a below-market multiple for those assets. This has always been the case and always will, in a free society (sovereign risk is one of our cost of capital metrics).

We will attempt to bring you some of those firms in this space. We will also point out firms which are selling at inexpensive valuations, but behind the financial curtain, are really risky securities to be avoided.

HISTORIC COST OF EQUITY, FREE CASH FLOW MULTIPLE AND S&P FAIR VALUE

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