What Did GM Really Earn In 1997? (1 of 3)
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*Graham and Doddsville Revisited* -- "The Intelligent Investor in
the 21st Century" (8/15/98)
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"The underlying principles of sound investment should not alter
from decade to decade, but the application of these principles
must be adapted to significant changes in the financial
mechanisms and climate." (Benjamin Graham)
*********
A Few Questions
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[A reader writes:] I .... have a few questions about
your methodology [see:
web.idirect.com],
which I hope you can address.
Fire away.
Is Working Capital "Free"?
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1) Let me note that most web financial reporting
services use the formula -- net income + depreciation +
amortization + depletion, minus capital spending (necessary
or discretionary) -- to compute what they call "free cash
flow." (They do not figure in changes in working capital, in
other words.) You prefer to use it to compute what you call
"cash earnings."
I have communicated with both Robert Hagstrom (author of The
Warren Buffett Way) and Roger Lowenstein (author of
Buffett: The Making of an American Capitalist) on this
issue. Both agreed that if cash is tied up in working capital,
it really isn't "free". However, some authors, for example
Cottle, Murray and Block (Security Analysis, 5th Edition),
point out that studies have shown that components of working
capital, like inventories and receivables, almost always get
converted to cash within a year. Therefore, they argue that
changes in working capital are a component of a firm's cash
generating power.
I look at it this way: Suppose Kline inherits a store. The
store is competently managed by hired help; and Kline has no
interest in running the business. Instead, Kline asks the
store's accountant to send her a check every month for the money
that the business doesn't need for ongoing expenses or future
growth.
Then one month there is a decline in the amount of the check
Kline receives. Upon inquiry, Kline learns that the store has
expanded. The expansion has required the store to stock and
shelve added inventory, and to have added currency sitting in
more cash registers, etc. It is true that the inventory is soon
likely to be cash and that the money in the till already is cash.
So, to that extent these additions to working capital do reflect
an increase in Kline's cash flow. But, Kline still isn't "free"
to take this cash out of the business.
Thus, I feel that changes in working capital do not necessarily
reflect a change in the cash available to shareholders. But then
again, in the case of cash accumulating in the company coffers,
they might. To avoid making further assumptions, I do not
attempt to identify those changes in working capital have changed
the company's cash value to shareholders and those that have not.
But, I also don't assume that an increase in working capital is
necessarily "free" to be distributed to shareholders. Hence, I
call the difference between cash flow and capital spending "cash
earnings", instead of "free cash flow".
Undervalued Compared To What?
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Fine. I have no problem with that. In fact, it even makes it
easier to
compare the current cash earnings situation of a particular
company to the Dow, or the S&P, or the whole universe of
stocks out there. You simply calculate the current P/CE
ratio for company A, and then compare that to the average
price/free cash flow ratios for the S&P, or for the industry
it's in, or whatever, supplied by the web reporting
services.
The problem comes with P/CE projections. I can see how you
would work out a 12-month, or a 5-year, projection for
Company A -- but for the whole S& P? For the whole industry?
That would involve working out ratios for every individual
company you wanted to compare Company A to, and then feeding
all that data into a computer program.
Do you have such a computer program?
I ask because the P/CE of
Company A would be meaningless, without some standard of
comparison, which could tell you whether its ratio was "too
high," "too low," or "just right."
I compare a company's P/CE ratio with that of the DJIA, which
over the long term is a pretty accurate proxy for the S&P 500. I use
Value Line data -- the subject of more than a little controversy
around here.
I enter the data by hand for each Dow stock into an Excel
spreadsheet. Unsurprisingly, there is more basis for confidence
in the aggregate of 30 Value Line earnings forecasts than for
the forecast for a single company. (See, for example: The
Intelligent Investor, 4th Ed., p. 153.)
I seek to identify relative, not absolute, value. If the
stocks selected by this method are undervalued relative to the
average for the Dow, there are very few long term scenarios in
which they will not outperform bonds or other asset classes.
(See, for example, market historian Professor Jeremy Siegel's
findings, reported in the WSJ, 8/11/98, p. C1)
The Importance Of Bears
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(Not that I want to invoke any bears here.)
Bears are vitally important. The only thing that is known with
certainty is that when the last bear stops roaring, it's time to
convert all holdings into gold bullion, and bury it in the back
yard.
Discounting The Value Of "Discounting"
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2) I notice you don't make any reference to
"discounting" the stream of future free cash flows/cash
earnings. Do you not use any discounting system at all?
I compare the 3-to-5-year cash earnings forecasts for the Dow
with Treasuries of similar maturity. As things currently stand,
the two are about at parity. The most recent auction of 5 year
Treasury Bonds yielded 5.32%. At current prices, the 3-to-5 year
cash earnings forecast on the Dow is just a hair's breadth over
5.0%. Admittedly, this is another way of saying there is little,
if any, margin of safety in today's Market, taken as a whole.
I've looked at the issue of discounting the cash earnings
projections for individual companies a number of times. At
present, I continue to feel discounting adds more uncertainty
than it removes. A recent article in "The Economist" provides an
excellent summary of historical changes in the "equity premium",
or "risk premium", i.e., the amount stocks can be expected to
earn over and above bonds in the long run. At present, there is
is no consensus about whether the premium was too high in the past,
or whether it is too low at present.
To arrive at an appropriate discount rate for a given company, it
is necessary to forecast the future equity premium. In turn,
this requires knowing future inflation rates, future real
interest rates, assuming reversion to the mean for future
earnings growth, etc., and assigning a risk premium that is
industry-specific. I feel this would require making far more
assumptions about the future than does using Value Line's cash
flow and capital spending forecasts to identify those stocks that
are undervalued in relation to other stocks.
Further, a colleague recently informed me that there is pretty
convincing data showing that, actually, stocks don't move in
relation to bonds that closely. Instead, the closer statistical
correlation is between stocks and the inflation rate. If so, it
suggests that discounting future cash earnings in relation to
interest rates may be misguided.
Naturally, if interest rates soar, or if the Dow shoots off the
charts, I will have to reconsider the issue of relative value.
Are Bonds A Form Of Savings?
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This reported disconnect between stock returns and bond returns
is consistent with my view that bonds are really more a form of
savings than an investment.
To my way of thinking, investment is the purchase of an income
generating asset, like common stock or real estate. The holder
of a bond hasn't really purchased an asset that generates income
in its own right. Rather, what the bond buyer has purchased is a
legally binding promise to be paid an amount certain -- the same
as a savings depositor -- rather than an undertaking in the potential
for gain or loss from future business performance.
It is true that the dollar-for-dollar return of the deposit can
be made at the depositor's demand in the case of savings.
Whereas, the bondholder must wait until maturity to demand the
face amount of the bond. But, this is similar to a "time
deposit", with the added feature of negotiability, i.e., the
right to sell the promise to repay to someone else -- possibly at
a higher price than the face amount of the promise.
In the case of Treasury Notes and Bonds, the guarantee that this
sum will be paid is at least as good as that which the savings
depositor receives from the FDIC -- possibly better, considering
who holds Treasuries.
So, neither the savings depositor nor the bond buyer purchase an
asset. Rather, they lend money to someone else -- a bank in the
case of a savings depositor, and a corporation in the case of a
bondholder. But, they never actually surrender their claim on a
return of the money loaned -- unlike the purchaser of an asset.
Thus, a bond seems to me to be a semi-liquid form of savings.
This view is supported by the relatively narrow divergence
between the returns on cash and those on bonds -- extending back
for very long periods -- and, conversely, the wide divergence
between both of them and the much greater returns on equities.
My view of precious metals is analogous.
How Much Debt Is Too Much?
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3) I also notice that you don't mention debt in your
methodology write-up. Doesn't debt have a bearing on cash
earnings? Take GM, one of the stocks in your Dow Value
Portfolio, for example. Sure, it has carloads of cash. It
also has high debt.
Some consider a lack of any debt an instance of "underleverage"
For example, owning real estate without a mortgage would be
underutilizing the underlying equity's power to buy more
income-generating real estate. Admittedly, no one would
accuse GM of underleverage.
Cyclicals Aren't Often "Great Companies"
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Let me quote some excerpts from
an on-the-one-hand, on-the-other-hand type of article on GM
that appeared on Morningstar.net recently.
First, the "on-the-one-hand" part:
Cyclicals....tend not to be great companies. They're
capital-intensive, and they usually need tons of debt to
leverage their operating returns on capital into competitive
returns on equity.
I agree that "cyclicals...tend not to be great companies." See:
Message 4172035
But, as Graham wrote, in theory at least, there is a price
at which any security is undervalued, or conversely, overvalued.
While I am more inclined to agree with Warren Buffett that's its
better to pay a fair price for a great company, in this case I
think all of the downside is more than reflected in GM's share
price.
And, there are different aspects to "greatness". GM certainly
isn't a great company in the the same sense that GE is. But,
being the biggest company in an important industry still implies
a certain measure of greatness. Using annual sales as a
benchmark, GM is the largest company in any industry.
Sometimes industrial giants go the way of, say, Western Union.
But, usually they eventually right themselves. And, in my
opinion, GM's 5-year record of improvement and the likelihood
that it will continue to get better is not yet priced into the
stock -- but just about every possible disaster scenario is.
The Problem With Debt
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The problem with debt is that it makes earnings more
volatile. That's because the interest expense on the debt is
a fixed cost that doesn't decline when a company's business
sours. So it reduces already poor earnings even further,
sometimes precipitating bankruptcy, or at least a big
restructuring. Combine heavy debt with a business that's
known to vary directly with the broad economic cycle, and
you're almost guaranteed losses every three to seven years,
along with all the trauma and upheaval associated with the
company's efforts to turn around. Not great company
material.
The "problem with debt" is that, alas, it eventually must be
repaid. Debt is just one component of a high overhead business.
But, it is typical of capital-equipment intensive industries,
since capital equipment is often purchased using a good
deal of debt (as with real estate, and hence, retailers and
fast food franchises).
...On the plus side, GM generates a lot of free cash
flow.
That's the "plus" I like.
This means
that even after spending money to upgrade its plant and
equipment-- and GM spends a lot, more than $10 billion in
1997 -- the company still has more than $6 billion left
over. With this money, it can pay more dividends, buy back
stock, pay down debt, build cash reserves, or make
acquisitions. GM has such low operating returns that it
doesn't make much sense for the company to hold on to its
free cash flow.
Just so.
Then why not use more of it to pay down debt? Or would
that depress ROA still further?
GM bonds yield somewhere between 6% and 9%, depending upon the
series. Notwithstanding the 2 dozen strikes of the past five
years, the common shares have a considerably higher average cash
earnings yield than the average interest yielded by the bonds.
Why not buy back the stock?
Are Currently Reported ROE's Believable?
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For example, GM's return
on equity...was 35% in 1997, in the same ballpark as
noncyclical Gillette's 29% ROE. But whereas Gillette's debt
level was just a fraction of is equity, GM's debt was 11
times -- yes, 11 times -- its equity. GM needed all that
debt to leverage up its lowly 2.7% operating profitability
(i.e., ROA). Gillette, on the other hand, generated an
above-average ROA of 13%, so it didn't need a lot of
leverage to jack up its return on equity.
I have expressed skepticism in the past that book values could be
as low (or, conversely, that price-to-book ratios could be as
high) as the published data indicate.
Recently, the WSJ (7/6/98, p. C1) published an article that
is relevant to this issue. Carla Haydn and Dan Givoly, accounting
professors at the University of California, have added up the
write-offs of book value taken by S&P 500 companies going back to
the 1950's.
Up until the mid-1970's, companies resisted taking special
charges against earnings and book value, and would only do so if
they could be "dumped" into a recession year, when expectations
were low anyway. But, since then, the trend has increasingly
been in the direction of taking net write-offs on an annual
basis.
According to the Haydn and Givoly research, by the end of 1996
the write-offs on the S&P 500 had accumulated to the point where
the reported book value was half of what it would have
been had the write-offs not been taken. There are many
inferences that can be drawn from this, and, as usual, some of
them might cut either way.
For one thing, if the Haydn and Givoly analysis is even
approximately accurate, it indicates that the earnings-to-book
value ratio (ROE), and price-to-book-value ratio on the Dow is at
the high end of the historical range, not "out-of-this-world", as
has been widely reported.
On the other hand, lower ROE's would imply a longer period for
equity purchased at current market prices to generate more
accumulated cash earnings than a bond of comparable safety. (See
further comments, below.)
GM's Book Value: The Incredible Shrinking Balance Sheet
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GM and many other companies in the early 1990's
took massive charges against their book values to recognize the
present value of costs that had been already accrued for the
medical expenses of future retirees.
These write-offs were, in effect, an admission that past earnings
were not as high as reported, since the cost of future medical
benefits had not been deducted from past revenues in the periods
when these benefits were accruing.
The write-offs of accrued medical benefits had the effect of
reducing GM's stated book value. They also had the effect of
making GM's ROE (earnings/book value) appear larger. Further,
they made the debt/equity ratio appear larger. Therefore, this
distorts comparisons of present ratios with those of the past.
"Non-Recurring" Charges Continue To Recur
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And, there is an ongoing impediment to understanding the
significance of these charges to book value and the ratios
derived therefrom. In recent years, GM, and many other
companies, have been closing unprofitable plants and downsizing
workforces through termination packages as a regular part of
their ongoing business plans. In the past, such events occurred
only as an ad hoc response to grave business conditions. So,
accounting rules permitted their treatment under categories like
"one-time", "nonrecurring", "extraordinary", or similar
descriptions.
The practice has become so common, that on average the operating
earnings of S&P 500 companies are about 10% higher than their
"net income" (the latter figure includes these "non-recurring"
charges), even in the boom year of 1997.
But, even if net income is used to calculate the current
earnings/book-value ratio, the Haydn and Givoly research
indicates there have already been so many write-offs in the past
that ROE appear about twice as large as it would have under the
accounting practices of the past. Correspondingly, past
write-offs also make the ratio of debt-to-equity appear much larger
than otherwise.
The critical issue, from the perspective of Intrinsic Value, is
what are the consequences of these balance sheet maneuvers for
how best to measure cash generating power -- currently, and going
forward. Unfortunately, this is not a question that has a simple
answer (but, see Graham's summarizing remarks, below).
[continued at: Message 5489178 |
