Digging Beyond Profit Margins


Randall Abramson, CFA
Portfolio Manager


Ronald Steinhoff, CFA
Portfolio Manager

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Digging Beyond Profit Margins

November 16, 2017

Profit margins for the S&P 500 constituents, excluding financials and companies in volatile sectors such energy and materials, have been steadily rising since the end of the 2001-2002 recession (Chart 1). The median 2016 EBITDA margin for this group was 22.6%, an all-time high. The median net margin came in at 9.6%, also an all-time high.

Companies have boosted operating margins by doing more with less—optimizing administrative functions, cutting managerial layers, and restraining advertising and R&D expenditures. The S&P 500 constituents recorded median revenue of $360,000 per employee, up from $263,000 in 2003 (Chart 3). Further down the income statement, net margins have risen due to lower effective tax rates (as international revenues as a percent of total sales have risen), and record low interest rates.

Cash flow trends have not been as rosy. While profit margins have risen, cash flow return on invested capital (CFROIC)—operating cash flow generated as a percentage of the total economic capital employed to generate said cash flow—has been flat-lining. Chart 3 illustrates that the median CFROIC has actually declined since 2003, from 16.9% to 16.5% today.

Our read of this is that projects that produce returns above capital costs are hard to come by. Realizing this, the largest companies in the world have zeroed in on cost cuts and diverted cash to share buybacks to prop up bottom line results. For the full S&P 500, rather than our adjusted group referred to above, revenue per share grew at an annualized 4.4% between 2003 and 2016 whereas earnings per share grew 6%. Over the same time period, ROIC declined from 7.8% to 7.2%.

Ultimately, the chickens must come home to roost. We expect that investors will eventually zero in on free cash flow and the productivity of capital. The S&P 500 currently trades at just over 13x EV/EBITDA, reflecting optimism about margins, global growth, and continued favorable central bank monetary policy. Valuations are high on a historical basis, and may turn out to be unsustainably high should the productivity of invested capital continue to decline.

Yield Curves Shifting and Flattening, but No Signs of Recession


Randall Abramson, CFA
Portfolio Manager


Ronald Steinhoff, CFA
Portfolio Manager

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Yield Curves Shifting and Flattening, but No Signs of Recession

October 5, 2017

We pay close attention to global yield curves. Yield curve inversions (i.e., short rates higher than long rates) have been reliable business cycle peak indicators in the past (see our previous Insight, How We Monitor the Economy).

Canadian and U.S. yield curves have converged over the last couple of years, mostly due to a rise in the 3-month U.S. Treasury yield to around 1%. Both curves have experienced a shift up in short rates with moderate movement at the long end—in other words, yield curve flattening (see Charts 1 and 2). The spread between 10-year and 3-month rates is at 1.2% for the U.S. and 1.1% for Canada.

While the curves are flattening, we’re not worried about a recession in either country—we’re just not seeing any other corroborating data points that are typically seen before the end of the business cycle. Unemployment rates in both countries continue to fall. Inflation remains subdued. U.S. capacity utilization, down from the 80%+ seen before the financial crisis, is holding steady at around 76%. Canadian capacity utilization is the highest in five years at 85%. According to ISM Manufacturing and Non-Manufacturing surveys, U.S. business executives continue to be optimistic about the economy.

We also don’t see any excesses or overheated debt levels that would trigger a recession. Most broad equity indices are fully valued, and there are pockets of runaway speculation (e.g., Tesla, Bitcoin), but we don’t see any overblown euphoria in broad equity values.  Nor do we see any abuse of potentially destabilizing financial instruments typically seen at the apex of market cycles (although these are tough to see in real-time).

The corporate earnings outlook is positive, and there has never been a recession when corporate earnings are expanding as they continue to today.

We’re not concerned about a recession, but we’re not without concerns. Developed markets have increasingly lofty future growth and margin expectations embedded at current levels. High quality, undervalued stocks with favorable risk/reward set ups are hard to come by. As a result, cash & cash equivalents comprise an overweight position in the portfolio of the Generation Global Value Private Trust while we wait for promising opportunities to emerge.

Most Valuable Brands Fully Valued


Randall Abramson, CFA
Portfolio Manager


Ronald Steinhoff, CFA
Portfolio Manager

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Most Valuable Brands Fully Valued

August 10, 2017

We seek to invest in undervalued companies with durable competitive advantages, clear growth prospects and positive industry dynamics. We pay close attention to companies with leading brands and loyal customers (think Apple, Nike) as these companies typically generate high returns on capital and strong free cash flows. On the flip side, we’re wary of companies with brands exhibiting declining consumer interest (think Under Armour, Ralph Lauren), even if shares look inexpensive. Turning around a challenged brand is a Herculean effort, requiring significant investments in marketing, product development and supply chain management.

For the last seven years, business magazine Forbes has produced a list of the world’s 100 most valuable brands. In our view, most of the leading brands are now fully valued. One way to look at a company’s valuation is to examine the implied long-term growth rate embedded in its current share price. This approach reverses the normal valuation approach. Fair value is set as the current share price. Then, with the discount rate and the one-year-out analysts’ average earnings per share estimate as known inputs, we solve for the growth rate. The result can be compared to historical growth expectations and the outlook for the company going forward. If implied growth is higher than historical levels then that might be a sign the stock is overvalued. Low expectations might identify an opportunity where the market’s expectations are out of touch.

Chart 1 plots the historical implied long-term growth baked into Forbes’ top 15 most valuable brands at each quarter end between Dec 31, 2005 and July 31, 2017. We made two adjustments to the group. Facebook, the fourth ranked brand, was removed because it went public in the latter part of the period. And we eliminated non-U.S. domiciled companies for a cleaner U.S.-only comparison. Toyota, Samsung and Daimler were replaced with the next U.S. domiciled companies on the list: Nike, Oracle and Verizon.

We present two implied growth calculation methodologies: one with the cost of equity set at a static 9% and one with the cost of equity fluctuating as the stock betas and the risk-free rate change quarter-to-quarter. Chart 2 compares the four higher-growth tech stocks—Apple, Google, Microsoft and Amazon—against the other 11 companies within the top 15 brands list. Implied growth for both groups is near pre-Great Recession levels.

Great brands, great companies. But with growth expectations now close to the levels recorded at the previous economic cycle peak, we do not see any inherent margin of safety. It appears that only significant margin expansion or upward shift of long-term growth expectations would drive shares materially higher—neither of which we foresee. Current net margins for the group are already 7% higher than the last cyclical peak and global GDP growth appears to be stalled at under 3%. Because of their full valuations we do not currently own any of the companies with the top 15 brands.

With a combined market cap of just over $4 trillion, these top 15 brands represent roughly 20% of the total market capitalization of the S&P 500 Index. Passive investors need to be aware of the full valuations of the underlying stocks within their Index ETFs (implying sub-par potential returns and/or vulnerability to declines from fair value). By digging a bit deeper though—albeit good values are scarce—one can still find attractive opportunities.

How We Monitor the Economy


Randall Abramson, CFA
Portfolio Manager


Ronald Steinhoff, CFA
Portfolio Manager

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How We Monitor the Economy

July 5, 2017

Monitoring the business cycle is of paramount importance. Since 1965, two-year rolling losses of 20% or more in the S&P 500 Composite Index have always been preceded by a business cycle peak. Equity markets tend to be more volatile following business cycle peaks than during periods of economic expansion.

To monitor the business cycle, we developed our Economic Composite. The cornerstone of the Economic Composite is the term structure. Research by Estrella and Mishkin (1996, 1998) and Wright (2006) concludes that the term structure (i.e., three-month yields less ten-year yields) is a viable tool for predicting business cycle peaks and has a longer lead time than other economic variables. Our research concurs with these studies.

Our model calculates the current term structure’s decile rank relative to historical spreads. Other economic variables such as the ISM survey, capacity utilization and the unemployment rate are also converted to decile ranks relative to their historical values. The decile ranks of each variable are combined into one master rank. When the decile rank of the master rank records a value of one (i.e., the bottom decile), then an Economic Composite business cycle peak warning signal is triggered.

In our historical study of U.S. business cycles, Economic Composite business cycle peak warnings preceded actual business cycle peak dates (as defined by the National Bureau of Economic Research, or NBER) by an average of 289 days. Since 1960, the average decline for the S&P 500 Index following an Economic Composite warning signal for the U.S. economy to the subsequent S&P 500 Index low was 26.1%. The latest Economic Composite warning signal for the U.S. economy occurred on October 27, 2006, 430 days before the NBER peak date of December 2007.

Figure 1 shows the historical NBER cycle peak dates, historical Economic Composite warning signals, and the historical trading price of the S&P 500 Index (log scale).

References

Estrella, Arturo and Frederic S. Mishkin (1998), “The Yield Curve as a Predictor of U.S. Recessions,” Current Issues in Economics and Finance, 2.

Wright, Jonathan H. (2006), “The Yield Curve and Predicting Recessions,” Finance and Economics Discussion Series Working Paper No. 2006-7.