Acquire instead of Hire: Signals that the Equity Markets are Undervalued & High Unemployment to Continue

The general thought process for senior managers running major corporations is how much return they will receive on their investment.  Back to my previous article on “The Monthly Employment Report, CEO's, Game Theory, & the Government”, the general theory is that senior management does not have the incentive at this point to take on risk spending their excess cash on risk projects only to potentially lose their jobs, if the project doesn’t pan out.

Let’s take this concept one step further and consider the relationship between the US equity markets and the unemployment number, from a big-picture thematic viewpoint.  

 

Given the historical precedence that is set when the Federal Reserve initiates open market operations to the tune that they have (0.0-0.25% overnight interest rates) for over 3 years now, one would think that the unemployment number would substantially decrease, even after the 6-9 month lag has been in effect.  However, this has not happen and the pesky unemployment number has been hovering around 9% for over 2 years now and many economists are forecasting this to be more of a structural problem that a cyclical short-term issue.  

 

If this is the case, where did all the money go since this liquid capital has not been used to hire employees and where should it go?

 

Well, if you look closer, the answer may be simple enough:  Eventually, senior managers will have to deploy their excess cash to projects once shareholders start to demand for a return on investment.

 

When this time comes (who knows exactly when that will be), the less risky way to deploy capital will be through firm acquisitions to create revenue or cost synergies on the company’s income statement.  In fact, recent M&A activity suggests that trends for buyouts were to increase in the coming quarters.  Since mid-2009, total equity values of global buyouts have increased approximately 13% annually and the average sized deal has increase to $73 million in 2011 from $62 million in 2009. (Source: Thomson Financial)

 

So, a typical senior manager (CFO or CEO) of a company will analyze a project and determine whether or not to invest, depending upon what the likelihood a project will succeeds in production of its cash flows.  Since there still are a ton of “known-unknowns” in the economy (US Gov’t deficit, Eurozone debt situation, Prospects of QE3, Future Monetary Policy, etc.), senior managers must apply a larger discount rate (cost of capital) to their projects, especially those that are organically grown (i.e. built from within the structure of the existing company).

 

With that in mind, the formula is quite simple:  In finance terms, it’s ROIC minus WACC, which means what is the Return on Invested Capital above the Weighted Average Cost of Capital.  If the ROIC is higher than WACC, then it makes sense to invest.  Also note that the largest component in the WACC is the cost of equity since highly-levered deals to fund projects are a thing of past.  If firms were allowed to use large amounts of leverage (projected over the long-term), we’d be having a different discussion, however, underwriting in the debt capital markets are back to non-insane levels like that of pre-2008.

 

So, when a senior manager determines whether or not to either (a) organically grow their firm and hire employees or (b) purchase an outside firm to solve that internal need, the answer will be a function of the cost of capital on organic projects and the valuation of firms to be acquired in the open market.

 

Currently, valuations in the US equity markets via P/E ratio are roughly trading at a 16x’s multiple which, in historical context, is slightly under the average (Source: Thomson Financial).  It’s very difficult, from the standpoint on the historic mean, to determine where the P/E ratio should be trading at and how long this bull market will continue, however, game theory suggests that senior managers will find less risk to acquire (or outsource) instead of organically growing internal projects.

 

With this is mind, I am bullish on the micro and small capitalization stocks for the next 6-12 months, unless the concepts above dramatically change in the short-run.  Unemployment will barely change greater than 1% over the next year since most senior managers will not take on the risk to hire at this point.

 

My next follow-up project to this paper will be to break down the specific sectors to determine which industries it will be more advantageous for senior managers to acquire than hire.  

 

Take care and Avenge!

Silver Trading slows and trades in a range...where's the opportunity?

I would like to elaborate on my May 2011 idea to go long straddles on Silver when the contracts value at 15% or less. 

The last two months (since the end of April), Silver (ETF - SLV) has been trading at a range between $32.00 and $37.50 per share and currently resides around $35.00.  A very important component to pay attention to on these contracts is that the volume is back to levels prior to April 2011.

If the average volume holds true over the next few quarters, one can expect a much less volatility on the action of the price.  Being the case, long straddles will not pay off since the current cost to put on the trade is 19% of the price out to October and 24% out to January 2012. 

Also, it appears the market has sustained limited volatility, even after the announcement of a potential default of Greece.

The writing is on the wall that we have a ton of liquidity in the market place to sustain a growing economy.  Whether the growth (over the long-run) is real growth is irrelevant as I'm in the camp that the price of volatility will decrease.

Since these contracts cost well of 15%, at this point, I feel the edge would be to those that are going short straddles and strangles on Silver and perhaps, other commodity investments.

Take care and Avenge!

The Monthly Employment Report, CEOs, Game Theory and the Government

Today, economists were way off on the non-farm payroll report, which stated that job growth for May was only 54,000 - versus a predicted 175,000.  In addition, the national unemployment rate rose from 9.0% to 9.1%.

As a result of this gross underestimation, equity markets opened down over 1% and bond markets rallied.  To add to the disappointment in job growth, House Republicans have publicly declared that "Obamanomics" has not worked, and employers' confidence has depleted due to the uncertainty in the U.S. Government being able to control the budget deficit.

I've always been in the camp to question everything that a politician says. However, I think they may be onto something with the statement about confidence.  At the end of the day, CEOs in the United States have a tough job (for those who create real value outside the financial services industry) and I believe they generally have the proper skills, background and incentives in place to lead their firm going forward.

With that being said - assuming I'm correct about my assumption that we have excellent CEOs in non-financial firms - why would CEOs want to risk their firm's liquid assets into projects that have a much greater degree of uncertainty than ever before? Assuming a smart decision maker, who were to invest in a project requiring a 5-year wait for a return on investment, and may anticipate (a) a slowing in consumer spending, (b) an increase in the savings rate, (c) increasingly massive government debt (d) a bloated Fed balance sheet, (e) a potential corporate tax rate hikes and (f) the Board of Directors not rewarding managers & CEOs for taking risk like they did in the past, why would any smart business leader want to hire someone when the risk/reward profile is not in balance?

If incentive structures were properly set up to compensate managers to take on additional risk in search of further growth & innovation, then perhaps more firms would hire.

The major problem can be described using Game Theory 101.  Back in business school, I learned simple yet powerful concepts on the theory of decisions and payoffs.

Currently, CEOs collectively have two major choices: (A) they can take risks, increase capital expenditures - hire employees, increase outsourced work, invest in technology, etc. - or (B) they can invest in the bare minimum to appease the shareholders and board of directors.

Now, an important component on the decision is the payoff.  For example, say the CEO chooses A and if the project succeeds, the payoff will be X and if the project fails, the payoff will be Y.

In addition, assuming the CEO chooses B and, if competitor's projects succeed, the payoff will be M and if the competitor's project fails, the payoff will be N.

The CEO's current dilemma is to decide whether or not to increase investment of their firm's capital.  In today's environment, the difference between Y and N (if the project fails), is not even close enough to warrant the ensuing risk to the CEO's job or career.  Even if the difference is relatively great between X and M (if the project succeeds), the dramatic difference to the downside is what causes the CEO's to not take the risk.

The key is to decrease the gap between case Y and N.

To take this one step further: since most, if not all, senior managers are taking the conservative approach, the risk/reward profile will not improve.  The increase in investing and hiring needs to get to a Tipping Point before other CEOs feel that they better start to put their firm's assets to work before the shareholders and board of directors lose patience and fire them.

Currently this is not the case and CEOs collectively sit on the sidelines.  It's a question of who will be the first brave enough to jump in, and then others feeling they have to follow suit.

If only our government - federal, state, and local - could inspire confidence among businesses of all sizes. Otherwise this "great recession" will only prolong itself even further.

Take care & Avenge!

When giving a Financial Advisor your money, ALWAYS do your homework!

In the modern era of the financial markets, specifically since the Reaganomics time in the 1980's when money became easy, the banking industry grew faster (except for Technology) than any other industry.  The growth of the banking industry led to legislation to de-regulate the Glass-Steagall Act to allow banks, insurance companies, and investment banks to merge.  This has been the top of mind or all of those on Capital Hill to determine what is best for the financial markets.

While all of this was going on, the financial media does not talk much about how much the financial advice industry has boomed.  In today's era, everyone is giving financial advice (and making a ton of money doing it) from branch banks, insurance representatives, advisors in discount brokerage houses, large investment banks, registered reps in the accounting field, and many others.  This means that you can leave your house to go to the grocery store and chances are you've passed at least five different places to get financial advice and park your investments.

What this means is that the loose regulations has allows just about anyone to obtain a Series 7 and Series 66 Licenses (Investment Securities Licenses necessary in order to legally get compensated) in order to make money offering one's expertise.

Here's the catch!  It's not so much how much experience (however, it's very important) the financial advisor has and how successful he/she is, it's what the framework of the "business model" is as to where this advisor is giving you advice.

Remember this:  The financial advisor that you speak or meet with face-to-face giving you the advice is spending most of their time selling to obtain commissions or recurring revenues.  This means that there may likely be a centralized model that has been designed and they are just executing on the model for sales purposes.   

The questions that need to be asked are as follows:

   1)  What are all the different investments that you offer to clients (irregardless of compensation)?
   2)  How much do you get paid (absolute amount and/or % of assets) regarding the different offerings at your firm?
   3)  If you are confined to only certain types of investments for clients to invest in, why is this the case and please provide the detailed research as to why you made this choices?  What are the relationships between these investment choices?  Are the proprietary or third-party?  Please explain the details on differences of compensation.
       ***This parts gets tricky because if you receive the data from the financial advisor, most of you will not understand what it means.  You will need to consult with a "trusted" expert that understand this information and they can help you make sense of it.
   4)  If you leave the company, who will be handling my assets?  (This question is important because if they answer the question with ease, that means you are a tiny part of a big system.  You need to be aware of this if you want a long-term personalized relationships.)

These are just some of the questions to consider, however, I don't want to provide too much information all in one published article.

Always keep in mind that the business model of the place you invest in is the most important indicator of your long term experience.  ALWAYS do your homework and find an independent person you trust to help answer your questions.   It's a complicated financial marketplace so it's always nice to have someone simply it for you.

Take care and Avenge-






 

Corporate Cash on the Balance Sheet and the Pathetic Media

What I find interesting is that the financial pornography like CNBC, FoxBusiness, Financial Times, WSJ, and all the other mainstream folks still mention every know and then that corporate cash on balance sheets at their all-time highs since World War II. 

I, too, have been plagued by this comment thinking, "Hey, perhaps all the money that's been pumping into the system from the Federal Reserve is going to paying down debt and increasing liquidity in non-financial firms.".....WRONG!

While the cash on balance sheets has been increasing (on an absolute standpoint), however, relatively speaking, the other liability side of the balance sheet has been dramatically increasing.  Since interest rates have been at all-time lows, CFO's tend to believe it makes sense to lend out on all ends of the yield curve assuming rates can only go up from here.  This idea makes sense only if the cash is being used to invest in projects that create positive NPV (Net Present Value).  Given all the uncertainties in the market and inflation, one would have to apply a larger discount rate to their projects making it more difficult for executives to want to invest in their company.  This is a very simple content, yet very applicable to the times we are dealing in today.

With that being said, I believe that shareholders are currently commending management with much higher stock prices in the last two years, however, C-level executives will need to start to put that cash to work.  And when that happens, the risk factor will increase even more since the debt levels have been on the rise.  If the Federal Reserve starts to increase rates and we have a shock in the yield curve, expect stock prices to drop dramatically to those firms that are once again overleveraged. 

Enjoy the article below that was printed nearly one year ago, however, I don't believe this information is stressed enough to the general public investor. 

http://www.businessinsider.com/about-those-supposedly-strong-corporate-balance-sheets-2010-8

Take care & Avenge!

Bonds should have little to no place in your portfolios

What I find very interesting is that over the past year, Energy, Materials, & Telecom Stocks (up 33%, 23%, and 25%, respectively) over the last 12 months, however, IT Stocks are up only 12%.  It appears that most of the excess capital poured into the market (QE2 and extremely low overnight rights) has gone towards stocks in the commodity linked sector such as Energy & Materials.

Much to my surprise, since corporations are still near all-time highs on Cash on their balance sheets ,that an increase in M&A, especially with IT like-kind acquisitions, and firms outsourcing, that equity prices have not been jumping in that sector.

From a Bond standpoint, I wouldn’t touch anything out there right now because spreads are way too tight due to the amount of liquidity in the market right now.  There’s WAY too much risk versus reward in many different scenarios.         

1)  Economy recovers & Unemployment decreases:  Fed tightens, demand shock upward, and yields rise.  Given all the mass inflows over the past 3 years (mutual funds, institutions, endowments) in fixed income, a way of sell offs will begin.  I’m not thinking defaults will be the case however demand will cause a drop in value

2) Economy continues to decline:  Unemployment worsens:  Fed will instill QE3 and rush to Treasuries will widen spreads even more.  The current 50-75 bps spread to take for corporates don’t make any sense.  If you want fixed income & bearish on the economy, Treasuries are the way to go.  Volatility will increase and correlation will go to 1.00.

3) Economy stays sluggish and we see stagflation:  Given the upside down yields (dividends higher than bond yields), investors forecasting a sluggish market for years to come will seek for high-quality cash flow intensive (& dividend paying) securities to invest in going forward.

Current P/E Ratios (trailing 12 months) in the S&P 500 are still well-below 20 which tends to be an indicator for increased equity prices, given historical prices in similar interest rate environments.  The yield curve is still steeply sloping and that trend doesn't look to be changing fast enough.  Lastly, cash on corporate balance sheets (non-financial corporations) are still near all-time highs which states demand is still pent up as corporations will eventually start to either a) payout to shareholders to spend b) increase in M&A or c) increase Cap Ex which may lead to job growth.

All in all, my thesis states that equities ( I like IT stocks the most) will be much more favorable for the next 12-18 months.

take care and avenge!

My first investment idea blog...Silver volatility is here to stay...

I have been investing & studying the markets for nearly 10 years and this blogging thing is all new to me so forgive me if my writing is not so structured & concrete.

This is my first ever blog and hope to continue to do this assuming people out there really care about my opinions.

I've been trading Silver (using the ETF: SLV) for over a year now and feel that I made a good directional call, however, the way to make money on these commodities is through a volatility play.  It's difficult to play 3+ months contracts out using a Straddle (long put & call at the money) because the breakeven (not assuming time value & implied vol) is at least 20%+. 

The key to this trade is when the cost hits around 15% to put on the trade.

Given the many, many uncertainties in the market (especially with inflation, Fed policy, global demand for commodities, european debt issues).

Well, I'm going to figure out additional ways to add more value with underline companies.

All in all, my general investment thesis, for all picks, results from my perception that the market doesn't know what it's looking at or there's an obstacle that is constraining the company whether from management, secular trends, access to capital, and ownership.

take care,
Avenge