Situation: At the beginning of each quarter, Merrill Lynch picks 10 stocks (often including two “shorts” to bet against). I have come to respect their picks but rarely act on those. Why? Because they are, for the most part, risky companies in risky industries. But when the Q3 picks came out on June 30, I was startled. Most of the picks are Dividend Achievers, i.e., companies with a record of increasing dividends for 10+ yrs. As the industry leader, with $2.2 Trillion in client assets under management, Merrill Lynch is encouraging its clients to make defensive investments. They see a Bear Market coming.
Mission: Highlight reasons to expect a Bear Market, and analyze the recommendations by Merrill Lynch.
Execution: The US economy is on solid footing. Jobs are becoming more plentiful, and wages are climbing faster than inflation. The unemployment rate in June 2016 was 4.9% (vs. 4.6% in June of 2006). However, labor market participation (62.7% in June 2016) hasn’t returned to it’s high from 10 yrs ago (66.2% in June 2006). When those who are underemployed (i.e., part-time workers), and those who are out of work but too discouraged to look for jobs, are added to the officially unemployed (i.e., job seekers), the “U-6” unemployment rate for June 2016 was 9.7% (vs. 8.4% in June 2006). Another problem is that many of the jobs that had been available to those without a college education, and paid well enough to allow those workers to become homeowners, have disappeared. The Information Revolution is replacing the Industrial Revolution but beneficiaries need to have a 4-yr college degree in math, science, engineering or technology to participate fully.
On a global scale, the US economy is an outlier. No other economy can be said to have recovered from the Lehman Panic. Great Britain was recovering but now faces recession due to fallout from Brexit. The rest of Europe is mired in economic troubles mainly caused by an over-reliance on debt financing that cannot be resolved without increases in productivity through education, “creative destruction” of outmoded industries and employment practices, automation, and increased free trade to leverage its competitive advantages. China has an “800 pound elephant in the room” called State-Owned Enterprises. Those continue to grow through municipal borrowing despite the best efforts of China’s economic leaders. Japan has found no way to emerge from decades of recession. Brazil and Russia are in deep recessions. India and South Africa are on growth trajectories but remain mired in structural unemployment. The “Arab Spring” unleashed unimaginable levels of discontent that remain poorly understood but affect the entire globe. The economies of those countries will remain in stasis until political solutions acceptable to those populations can be implemented. What is the “root cause” for underperformance in so many regional economies? Experts point to modern communications, like social media. Anyone with access to a cell phone, laptop or TV is a candidate to develop a more materialistic lifestyle, by whatever means necessary.
We don’t know how the next Bear Market will be triggered, so the S&P 500 Index continues to make new highs driven by ever-lower interest rates. There are many candidates, overvaluation being prominent among them, with the S&P 500 Index sporting a P/E of 25. Growth of the US economy (GDP) faster than 3%/yr could cure that problem but it doesn’t appear to be happening. Perhaps our government agencies, our corporations and our households have borrowed too much money, and interest payments consume too much of those budgets to allow enough investment in growth. There is also too much uncertainty about the future, so companies are reluctant to move forward with hiring and expand operations. No one issue, whether Brexit or the upcoming US election, has the capacity to trigger a recession on its own. But the above-mentioned points will amplify any crisis atmosphere that arises out of a destabilizing event like a natural disaster, a nuclear accident, or a civil war.
Administration: The Merrill Lynch Q3 recommendations include two candidates for short sales and a company that recently went public. We’re not interested in those. But do check out the other 7 (including 6 Dividend Achievers) that are worth a look by anyone seeking “buy-and-hold” stocks for a retirement portfolio (see Table).
Bottom Line: Merrill Lynch analysts apparently think a Bear Market is coming soon, and have advised clients to pick stocks that are likely to hold value in such an environment. Seven appear suitable as long-term holdings (see Table). Six of those are Dividend Achievers: NextEra Energy (NEE), Realty Income (O), AT&T (T), Raytheon (RTN), Walgreen Boots Alliance (WBA) and Lowe’s (LOW). The non-dividend paying stock, salesforce.com (CRM), is the seventh and has growth prospects that could support continued price accumulation in a recession. However, our analysis suggests that only NEE is worth buying when the market is overheated (see Table).
Risk Rating: 6 (Treasuries = 1 and gold = 10)
Full disclosure: I dollar-average each month into NEE and T.
NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 13 in the Table. Net Present Value inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = the moving average for stock price over the past 50 days (corrected for transaction costs of 2.5% used to buy ~$5000 worth of shares), Dividend Growth Rate is Dividend CAGR for the past 16 years, Price Growth Rate is the mean Price CAGR for the past 16 years (http://invest.kleinnet.com/bmw1/), and Price Return for selling shares in the 10th year is corrected for transaction costs of 2.5%. The NPV template is found at (http://www.investopedia.com/calculator/netpresentvalue.aspx).
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Showing posts with label leverage. Show all posts
Showing posts with label leverage. Show all posts
Sunday, August 14
Sunday, July 29
Week 56 - What is Private Equity and Why Has It Become a Political Football?
Situation: Back in the day, the division of an Investment Bank that bought companies for a client was referred to as “Acquisitions.” Likewise, the division responsible for subsuming a newly purchased company into another company was called “Mergers.” Then, in the 1980s, we had Investment Banks that performed “leveraged buyouts” by using lots of borrowed money to accelerate the process. That fell into disfavor and has given way to a new nomenclature, “Private Equity,” where private investors take a company out of the public sector (its stock is no longer traded on an exchange) and into the private sector. Indeed, there no longer are any Investment Banks. The last two (Morgan Stanley and Goldman Sachs) converted their charters in 2008/09 to become government-regulated commercial banks.
The truth is that Private Equity does exactly what it says: Private investors buy up all the exchange-traded stock of a struggling public company, which removes that company from SEC (Securities & Exchange Commission) regulation. The purchased company no longer produces quarterly/annual reports, and the investing public no longer has access to its balance sheets, income statements, and statements of cash flows. Then a new management team tries to turn the company around by using its last remaining ammunition (cash flow) and adding lots of newly borrowed cash. If the company’s existing Business Plan is no longer considered viable, it is summarily terminated to make way for innovation, asset sales, and layoffs (“right-sizing”). The purpose of these drastic changes is to restore profits while preserving as many jobs as possible. This process was labeled “creative destruction” in a 1942 book by the late Joseph Schumpeter (1983-1950), the famous Harvard economist. While that excellent book is abstract theory, there is a new book that reveals the living, speaking faces of people who “creatively destroy” a plant and its equipment: “Punching Out: One Year in a Closing Auto Plant” by Paul Clemens (2012, ISBN: 978-0-385-52115-4). We recommend it.
Creative destruction is the ugly part of the story. The pretty part is that the new managers have the advantage of a fresh start, better pay, and more money to spend. The new managers are really no smarter than the old managers (who knew the company and its workers better), and given enough guts, focus, vision, innovation, and borrowed money, most of the original managers and workers probably could have kept their jobs--at least in theory. But does that ever actually happen? Rarely. Check out Ford Motor Company, which did accomplish it. In 2005, Chairman Bill Ford asked the Americas Division President (Mark Fields) to come up with a plan for downsizing and innovation. Mark Fields’ proposal, The Way Forward, was accepted by the Board of Directors in January of 2006. (It looked to be right out of the Private Equity toolkit.) In September of 2006, a new CEO, Alan Mulally, was brought in to execute the plan. He started everything rolling in a BIG way by mortgaging the entire company for $25B. He even mortgaged the logo! The rest is now history. Ford was the only major auto manufacturer that didn’t need a government bailout; it turned a $2.7B profit in 2009 and its retiree health benefit plan was fully funded by the end of 2010. Ford (F) now pays a 2.1% dividend (15% of estimated net income) and has an S&P credit rating of BB+.
Private Equity comes into play when the internal cash flow of a public company is no longer sufficient to maintain its property, plant, and equipment at a competitive level (let alone meet its payroll). The distressed company is said to be “burning cash”. Its stock and bond holders are giving up and selling out at a loss. The company is on the verge of declaring bankruptcy. In this scenario, Private Equity represents its last chance to survive. So, Private Equity is about securing a big loan to a) buy the company and b) make improvements in the company’s cash flow with the hope of taking it public in the future. The new management team often pays itself premium salaries because attractive compensation is thought to incentivize performance, and because they could soon be out of work in spite of their best efforts. (Remember what happened when Cerberus Capital Management took Chrysler private in 2007?) Officers of the newly reconstituted company also enjoy the advantage of less “friction”. For example, there are no time-consuming (and labor intensive) Sarbanes-Oxley reports to file. Nothing magical has been added to the mechanism for making the company’s new Business Plan effective but the glue & sand have been removed from the working gears and levers. How does that work? It works because borrowed money is used to tide the company over while new management fixes problems that had been obvious to old management for some time.
Private Equity was an opaque backwater of finance until the current political season turned “Bain” into a household word. Editorial coloration around that word has often shifted to the red end of the spectrum, suggesting that Bain Capital is doing The Devil’s Work. But the CEO of another finance company has suggested that Private Equity is “doing God’s Work.” Wherein does the truth lie? You’ll have to decide for yourself.
Bottom Line: There is nothing magical about Private Equity. Think of it as extra dollars being deployed by good managers who are trying to save a company by using an innovative new business plan (combined with the sale of outmoded assets), free from prying eyes looking to “see how the sausage is made.” It’s basically the same as Public Equity (where the success rate is about the same if you include government bailouts) but needed changes happen more quickly and quietly. This is something which pleases private investors and makes financing easier to obtain for companies in trouble. Private Equity has now become a political football because
a) layoffs happen faster and are often permanent,
b) the new managers are paid well whether or not they save the company, and
c) it happens outside the public sphere and SEC regulation.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
The truth is that Private Equity does exactly what it says: Private investors buy up all the exchange-traded stock of a struggling public company, which removes that company from SEC (Securities & Exchange Commission) regulation. The purchased company no longer produces quarterly/annual reports, and the investing public no longer has access to its balance sheets, income statements, and statements of cash flows. Then a new management team tries to turn the company around by using its last remaining ammunition (cash flow) and adding lots of newly borrowed cash. If the company’s existing Business Plan is no longer considered viable, it is summarily terminated to make way for innovation, asset sales, and layoffs (“right-sizing”). The purpose of these drastic changes is to restore profits while preserving as many jobs as possible. This process was labeled “creative destruction” in a 1942 book by the late Joseph Schumpeter (1983-1950), the famous Harvard economist. While that excellent book is abstract theory, there is a new book that reveals the living, speaking faces of people who “creatively destroy” a plant and its equipment: “Punching Out: One Year in a Closing Auto Plant” by Paul Clemens (2012, ISBN: 978-0-385-52115-4). We recommend it.
Creative destruction is the ugly part of the story. The pretty part is that the new managers have the advantage of a fresh start, better pay, and more money to spend. The new managers are really no smarter than the old managers (who knew the company and its workers better), and given enough guts, focus, vision, innovation, and borrowed money, most of the original managers and workers probably could have kept their jobs--at least in theory. But does that ever actually happen? Rarely. Check out Ford Motor Company, which did accomplish it. In 2005, Chairman Bill Ford asked the Americas Division President (Mark Fields) to come up with a plan for downsizing and innovation. Mark Fields’ proposal, The Way Forward, was accepted by the Board of Directors in January of 2006. (It looked to be right out of the Private Equity toolkit.) In September of 2006, a new CEO, Alan Mulally, was brought in to execute the plan. He started everything rolling in a BIG way by mortgaging the entire company for $25B. He even mortgaged the logo! The rest is now history. Ford was the only major auto manufacturer that didn’t need a government bailout; it turned a $2.7B profit in 2009 and its retiree health benefit plan was fully funded by the end of 2010. Ford (F) now pays a 2.1% dividend (15% of estimated net income) and has an S&P credit rating of BB+.
Private Equity comes into play when the internal cash flow of a public company is no longer sufficient to maintain its property, plant, and equipment at a competitive level (let alone meet its payroll). The distressed company is said to be “burning cash”. Its stock and bond holders are giving up and selling out at a loss. The company is on the verge of declaring bankruptcy. In this scenario, Private Equity represents its last chance to survive. So, Private Equity is about securing a big loan to a) buy the company and b) make improvements in the company’s cash flow with the hope of taking it public in the future. The new management team often pays itself premium salaries because attractive compensation is thought to incentivize performance, and because they could soon be out of work in spite of their best efforts. (Remember what happened when Cerberus Capital Management took Chrysler private in 2007?) Officers of the newly reconstituted company also enjoy the advantage of less “friction”. For example, there are no time-consuming (and labor intensive) Sarbanes-Oxley reports to file. Nothing magical has been added to the mechanism for making the company’s new Business Plan effective but the glue & sand have been removed from the working gears and levers. How does that work? It works because borrowed money is used to tide the company over while new management fixes problems that had been obvious to old management for some time.
Private Equity was an opaque backwater of finance until the current political season turned “Bain” into a household word. Editorial coloration around that word has often shifted to the red end of the spectrum, suggesting that Bain Capital is doing The Devil’s Work. But the CEO of another finance company has suggested that Private Equity is “doing God’s Work.” Wherein does the truth lie? You’ll have to decide for yourself.
Bottom Line: There is nothing magical about Private Equity. Think of it as extra dollars being deployed by good managers who are trying to save a company by using an innovative new business plan (combined with the sale of outmoded assets), free from prying eyes looking to “see how the sausage is made.” It’s basically the same as Public Equity (where the success rate is about the same if you include government bailouts) but needed changes happen more quickly and quietly. This is something which pleases private investors and makes financing easier to obtain for companies in trouble. Private Equity has now become a political football because
a) layoffs happen faster and are often permanent,
b) the new managers are paid well whether or not they save the company, and
c) it happens outside the public sphere and SEC regulation.
Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com
Sunday, August 21
Week 7 - Risk
Situation: Each day the stock market attempts to determine what a company’s earnings will be 6-9 months in the future, and how much of a premium investors will pay for that stream of revenue. This process is called “price discovery” and represents a tug of war between shorts (betting the price will be lower) and longs (betting the price will be higher). Stock traders, companies, and governments all understand the power that leverage (borrowed money) has to enhance the outcome (win or lose) of their investments. Leverage is the key element of risk, even though the fundamental value of a company or nation may otherwise be beyond doubt. In 2008, we found out what happens when Wall Street uses leverage unwisely. Then our government borrowed $4 Trillion to cover Wall Street’s debts (and the debts of Government Supported Entities that guarantee mortgage loans) and leverage took on a whole new meaning. Washington became the financial center of our nation, it’s power over the markets is now several fold greater than before 2008: stock traders know that the face cards are now played in Washington. Hence, when the “ship of state” is listing to port (as indicated by the recent Treasury bond rating down-grade from AAA to AA+ issued by Standard and Poor’s), Wall Street will panic.
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
In Washington, the main decisions affecting the stock market are made by the Federal Reserve as it sets monetary policy (interest rates), and Congress as it sets fiscal policy (expenditures). Both groups made key decisions in the days prior to the S&P announcement. While the decisions made represent timid (but nonetheless deflationary) course corrections that might succeed in pulling us back from the abyss of a national debt spiral, which is why the remaining ratings agencies (Moody’s and Fitch) did not go along with S&P’s decision. Taken together, these 3 actions:
(a) to lock the Federal Funds interest rate at 0-0.25% for 2 years;
(b) decrease Federal spending by $2.1-2.4 Trillion over 10 yrs, and
(c) the S&P downgrade
have rattled markets around the world. The NY Times put a fine point on it with a quote from a trader “if risk reprices, risk reprices across the board” (8/14/11). What risk? Well, it’s the risk that the deflationary policies put in motion by the Fed, Congress, and S&P will nip growth in the bud and possibly start another recession.
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
<click here to move to Week 8>
Goal: The act of saving for the future (by paying into investments now) is fraught with risk: all asset classes go through periods of under valuation when there are not enough buyers vs. over valuation when there are too many buyers. While governments have an increasingly disruptive effect on a company’s financial planning, there are basic ways to assess the risks associated with a company's business plan. This week's ITR post we will introduce risk by outlining the parameters used for its assessment, then apply these parameters to stocks selected for inclusion in the ITR Growing Perpetuity Index.
<click this link to view the Risk Table>
S&P QUALITATIVE RISK (S&P Qual Risk): S&P uses this term in evaluating the business plans of the 500 companies in its Index. Financial stability is a minor part of this analysis; for the most part, strategic issues are addressed. These are issues that determine whether or not the company will retain the ability to sell its products or services at a profit. The strategic issues used to make this determination are described by Michael E. Porter (Competitive Strategy, The Free Press, New York, 1980) and include
a) the threat of new competitors,
b) the threat of substitute products or services,
c) the bargaining power of suppliers,
d) the bargaining power of buyers, and
e) rivalry among existing firms.
S&P CREDIT RATING OF COMPANY BONDS (S&P Bond Rating): The capital structure of almost every company in the S&P 500 Index includes loans that have to be paid back on a date certain, as opposed to loans such as mortgages where principal payments are made over the life of the loan. The risk of a loan not being repaid on time = the risk of bankruptcy. When a company declares bankruptcy, its stock becomes worthless and its bondholders divvy up the company’s property, plant, and equipment at a fire sale. An S&P credit rating of BBB- or better is termed “investment grade” and implies a remote risk of bankruptcy. Before the 2008 recession, there were 8 non-financial companies with the highest (no risk of default) AAA rating: XOM, JNJ, GE, PFE, ADP, BRK, and MSFT. Now only 4 retain AAA status: XOM, JNJ, ADP, and MSFT.
LONG-TERM DEBT TO EQUITY (LT Debt/Eq): Companies issue long-term bonds to obtain cheap capital for a long period of time. When those loans come due, the company has to produce tens or hundreds of millions of dollars and return the loan principal to its owner. Usually, companies simply “roll over” the debt and issue a new bond in the same amount and long-term period of maturity. However, that moment is not always propitious - interest rates may be high, or the company credit rating may be low due to a cash-flow crunch. If the company has retained earnings on its balance sheet, these can be deployed to pay down the debt, or the company may exercise its option to issue more common stock. But if the company is mainly financed by issuing long-term bonds, a problem will arise at some point in the future - such as a recession when it is expensive to roll over debt or find buyers for more stock. With the exception of companies that are state-regulated utilites (e.g. NEE), LT Debt/Eq should be less than 90%.
TOTAL DEBT TO EBITDA (Debt/EBITDA): EBITDA is an arcane accounting term that will keep popping up because it means real earnings: Earnings Before allowance is made for Interest payments, Taxes, Depreciation, and Amortization of fixed costs. Unless the company is a state-regulated utility, Debt/EBITDA should be less than 90%.
BOLLINGER BANDS FOR MOST RECENT YEAR (1 yr B-Bands): An interactive graph (c.f., Yahoo Finance) of the daily price of the S&P 500 Index has a “technical indicators” tab with an option for graphing B-Bands. When set at 250 days (i.e., one yr of trading days) and a variance (standard deviation) of 3, the S&P 500 Index graph has lines above and below. The S&P 500 Index price will sit between these 2 lines for more than 95% of trading days. Exceptions show that the index is temporarily either over-bought (high) or over-sold (low). We added stocks from the Growing Perpetuity Index alongside the S&P 500 Index and asked “Does the stock price remain outside or inside B-Bands for S&P 500 Index?” Outside indicates the deviation is significant and this deviation will someday be matched by such a deviation in the opposing direction (Volatility Risk).
RETURN ON ASSETS (ROA): The annualized return on deployed capital (common stock, preferred stock, IOU-type “commercial paper” loans, and bonds issued by the company). When ROA exceeds the interest rate on the largest outstanding bond, the company is solvent and has an investment-grade credit rating. Trouble begins in a recession when the company isn’t making as much money but still has to service its debt. ROA can become less than sufficient to cover interest payments. When ROA is less than 10% an investor has to wonder whether the company’s management is wise to use debt as a major tool for capitalizing its expansion plans. Boards of Directors often favor the use of debt because the company does not pay taxes on interest, thus making the IRS an uncompensated source of capital.
MERRILL LYNCH VOLATILITY RATING (ML Volatility Rating): Merrill Lynch assigns a letter grade to Volatility Risk for large companies. This information is not as specific or up-to-date as 1yr B-Bands but has nevertheless withstood the test of time.
Bottom Line: The Risk Table shows how Growing Perpetuity Index stocks stack up in terms of risk. JNJ alone emerges with a clean slate, however, the 11 others are relatively well-insulated compared to most companies in the S&P 500. NEE is a special case because the largest subsidiary of its holding company is Florida Power & Light, a regulated utility and, as a government-supported entity, it’s bonds are backed by the State of Florida.
Volatility in the price of a stock encapsulates the totality of risks being taken by management and leverage is the most important. “This is the peril that haunts even the savviest financiers. Leverage raises the bar for survival. It requires that one is ever able to access credit.” (Roger Lowenstein, The End of Wall Street, The Penguin Press, New York, 2010, p. 212.) In 2011 the S&P 500 Index has seen considerable volatility. As of COB on 8/17/11, that index was down 5.1%. When total returns (dividends & price change) for SPY are compared to the 12 stocks in the GPI over that period, SPY has a negative return of 3.93% whereas GPI has a positive return of 4.82%: total returns of GPI stocks are 8.75% more than the benchmark index. Why is the difference so large? Because leverage amplifies market volatility: downward moves detract from the value of over-leveraged stocks more than from the value of under-leveraged stocks. The ratio of Total Debt to Total Equity for the S&P 500 Index is 1.20 (120%) vs. 0.62 (62%) for the ITR Growing Perpetuity Index.
What you need to remember: Risk is hard to define but easy to track: it always gets transferred to less knowledgeable hands. Sometimes those are the hands of professionals. Bankers on Wall Street are a recent example. They created, and sold to the unwitting, CDOs (collateralized debt obligations) consisting of bundled sub-prime mortgages. Then, while knowing that these were “junk bonds”, they kept billions of dollars worth in their own bank’s vault! But usually risk ends up in the hands of novices (or professionals who try to invest in an asset class they don’t understand). We have witnessed, on a global level, the result of professionals (and governments) taking risks in an arena they neither understood nor properly investigated.
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