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"New Normal" stocks


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I just got done reading the monthly CFA magazine and it has 2 good articles.  One is an interview with Prem and another supports stocks in the "new normal" environment of slower growth as excess debt is being worked out at the individual and gov't levels.  One item noted that was positive for stocks is the slower growth will require less investment and thus more cash for firms to do buybacks or increases in dividends.  This appears to be happening now with the resultant firm cash build-ups, slow loan demand growth and slow employment growth.  Another finding was that alot FCF growth per share was going to come from repurchases versus actual growth.  This is exactly how Henry Singelton grew Teledyne in the slow real growth 60s and 70s.  Out of lets say an 7% growth rate per share, 5% is going to come from income/return of capital (2% from yield and 3% from buybacks) and 2% from real growth.  I think this article points out a source of equity returns (buybacks) that have been common in some sectors (large cap tech) in the past 5 years but may become more common across all sectors as growth moderates.  

 

One offshoot is to test the normal growth rates in stocks in your portfolio.  I think the most danger comes in production growth for a 5 -6% growth world when 2% is more appropriate leading to overcapacity.  The stocks in my portfolio that has the highest risk is SSW and some O&G firms.  SSW has protected itself via LT contracts to creditworthy customers but I think O&G stocks are exposed.  What has driven O&G stocks has been increasing demand with steady or declining output but if that demand levels off or declines I think we may have reached "peak prices".  I had been an O&G bull but now I am more cautious. Any other thoughts on how to test stocks for the "new normal" would be appreciated.

 

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The assumption is that surplus cash buys back stock; it does not repay debt to restore D/E ratios, it does not get paid out in 'special' dividends, & it does not pay carry cost on new acquisitions debt.

 

Industry's that use acquistion as a tool (O&G, resources), lack capital discipline (airlines), & have capital issues (banks) are probably not good targets. Industry's with very high depreciation (railroads) & long-lived assets  are probably good.

 

SD

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I am generally not a fan of stock buybacks because so few are done well.  In the olden days of Ben Graham and Warren Buffett companies with excess capital gave it back to shareholders as dividends.  I know people will point out that dividends are tax disadvantaged but I still prefer it ro badly done share buybacks.  I can only think of very few companies that do buybacks well.  The vast majority of time buybacks are used to bolster the share price in the short term and mouth the words shareholder value.

 

Dividends on the other hand tend to focus management on cash production, make shareholders wealthier, and help governments raise money.

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If you look at some of the larger tech cos like IBM, TXN, HPQ, AMAT, INTC, CSCO, MSFT, DELL and LXK They all, in my opinion, have done value enhancing share repurchases and this is how they will increase FCF per share going forward in concert with small organic revenue grwoth.

 

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SharperDingaan: What's your reasoning behind "industry's with very high depreciation (railroads) & long-lived assets are probably good" with low real GDP growth? Do you like the inflation optionality? Is your reasoning that these companies have assets to backstop valuation/buyback?

 

Personally, I want good capital allocation by management--implicitly means a competitive advantage--and good valuation. Teledyne seemed to be able to buyback stock effectively because it was misunderstood/neglected by the market and had good capital allocation. In the '60 and '70, buybacks were viewed negatively by the market in the US... Anyone know why?

 

 

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Depreciation is a non cash expense, but if you're profitable - you recovered the expense when the buyer of your goods/services paid (cash) for them. If the underlying business is not growing - you dont need additional rolling stock, you can use fewer engines (replacements can pull more than the old), & operating costs shrink (fuel & labour savings). Capex becomes NEGATIVE, & the CEO/CFO has a mountain of surplus net cash inflow to bolster results - for a number of years.

 

Agreed, if surplus cashflow is returned to investors via a dividend - they can reinvest in higher yielding assets elsewhere (inflation optionality). However, most CEO/CFO bonus structures favour buy-backs to reduce dilution, increase earnings & multiples, & elevate share price. The surplus net cash inflow is essentially capitalized; & you reinvest elsewhere by selling your shares.

 

The discipline advantage of railroads is that it is difficult to sell the idea of expanding track or buying another rail-road unless it directly connects to you. Authorities do not appreciate monopolists, & most shareholders do not want that surplus net cash inflow going on anything but buy-backs. It also doesn't hurt that to get that adjacent rail-road you will have to over-pay.

 

The operating advantage of onging falling variable costs, & higher freight prices (inflation), just improves margin & further diversifies the surplus net cash inflow (reduced volatilty).

 

Point(s) 1) Yes we like the inflation optionality because we expect it to be capitalized 2) CEO/CFO is incentivised to make it happen.

 

SD

 

 

 

 

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Depreciation is a non cash expense, but if you're profitable - you recovered the expense when the buyer of your goods/services paid (cash) for them. If the underlying business is not growing - you dont need additional rolling stock, you can use fewer engines (replacements can pull more than the old), & operating costs shrink (fuel & labour savings). Capex becomes NEGATIVE, & the CEO/CFO has a mountain of surplus net cash inflow to bolster results - for a number of years.

 

Agreed, if surplus cashflow is returned to investors via a dividend - they can reinvest in higher yielding assets elsewhere (inflation optionality). However, most CEO/CFO bonus structures favour buy-backs to reduce dilution, increase earnings & multiples, & elevate share price. The surplus net cash inflow is essentially capitalized; & you reinvest elsewhere by selling your shares.

 

The discipline advantage of railroads is that it is difficult to sell the idea of expanding track or buying another rail-road unless it directly connects to you. Authorities do not appreciate monopolists, & most shareholders do not want that surplus net cash inflow going on anything but buy-backs. It also doesn't hurt that to get that adjacent rail-road you will have to over-pay.

 

The operating advantage of onging falling variable costs, & higher freight prices (inflation), just improves margin & further diversifies the surplus net cash inflow (reduced volatilty).

 

Point(s) 1) Yes we like the inflation optionality because we expect it to be capitalized 2) CEO/CFO is incentivised to make it happen.

 

SD

 

   

 

   

 

Good account, but nothing is forever.  Penn Central put off necessary capex for many years, and then suddenly went bankrupt to the surprise of Ben Graham and many others!  :o

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Thank you SharperDingaan!

 

Twacowfca: How do you tell if a capital-intensive business is under-investing? Look at deprec/maintenance capex ratio? You trust management, while looking at incentives? For example, SHLD ("under-investment" at Sears has been widely debated, although I'm not sure it's the best example). It seems SharperDingaan's reasoning includes industry structure and dynamics not present in Penn Central's time--like higher pricing due better fuel efficiency vs. alternative transport. Understanding industry structure and dynamics seems very important and also takes the most time. I love reading Ruane, Cunniff & Goldfarb annual meeting transcripts because it's full of discussions about each company's position and strategy within an industry!

 

I suppose labor-intensive business like technology stocks have cultural risks in a changing industry and world---cultural DNA as they say.

 

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Penn Central put off necessary capex for many years, and then suddenly went bankrupt to the surprise of Ben Graham and many others!   :o

 

Not sure what you mean by that.  Perhaps the bankruptcy itself was a surprise, but Graham noted many times, particularly in the 4th edition of The Intelligent Investor that even as late as 1968 through standard tests and analysis that no shares or bonds of Penn Central should have remained in any securities account watched over by a competent analyst.  So anyone following his methods would not have been caught with Penn Central securities even if the ultimate resolution (i.e. bankruptcy) can never be predicted with any certainty.

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Penn Central put off necessary capex for many years, and then suddenly went bankrupt to the surprise of Ben Graham and many others!   :o

 

Not sure what you mean by that.  Perhaps the bankruptcy itself was a surprise, but Graham noted many times, particularly in the 4th edition of The Intelligent Investors that even as late as 1968 through standard tests and analysis that no shares or bonds of Penn Central should have remained in any securities account watched over by a competent analyst.  So anyone following his methods would not have been caught with Penn Central securities even if the ultimate resolution (i.e. bankruptcy) can never be predicted with any certainty.

 

Thanks for the clarification.  Apparently, BG himself had not been following Penn Central closely in his retirement when their bankruptcy took many by surprise.  :)

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Thank you SharperDingaan!

 

Twacowfca: How do you tell if a capital-intensive business is under-investing? Look at deprec/maintenance capex ratio? You trust management, while looking at incentives? For example, SHLD ("under-investment" at Sears has been widely debated, although I'm not sure it's the best example). It seems SharperDingaan's reasoning includes industry structure and dynamics not present in Penn Central's time--like higher pricing due better fuel efficiency vs. alternative transport. Understanding industry structure and dynamics seems very important and also takes the most time. I love reading Ruane, Cunniff & Goldfarb annual meeting transcripts because it's full of discussions about each company's position and strategy within an industry!

 

I suppose labor-intensive business like technology stocks have cultural risks in a changing industry and world---cultural DNA as they say.

 

 

Please let me know if you can find a magic formula that will reveal this; then we'll both know.  :)  One red flag might be capex significantly below industry peers.  When in doubt, go see for yourself.  Example: American Airlines has a very old fleet of planes that has frequent disruptions of service to fix something, not to mention pieces of planes falling off in flight.

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