Company Notes Digest 12.11.15

Each week we read dozens of transcripts from earnings calls and presentations as part of our investment process. Below is a weekly post which contains some of the most important quotes about the economy and industry trends from those transcripts. Click here to receive these posts weekly via email.

This Week’s Post: Ground Control to Major Tom…Commencing countdown, Engines On…

The Fed may raise interest rates off of the zero bound for the first time in seven years next week. I know we’ve all got Fed fatigue, but this really is an important shift in policy.

Goldman held a financial services industry conference this week, so we got to hear from a lot of management teams who will be most affected by the change. Everyone expects the Fed to move, but will be watching the commentary closely for indication of future increases. The consensus seems to be that future increases will be slow. Banks should benefit from the increase, but it’s anyone’s guess how the rest of the economy will react.

Also this week: What are high yield spreads saying about credit quality in non-energy sectors? AT&T and Verizon confirm that handset sales are weak this quarter, and energy companies continue to search for a bottom.

The Macro Outlook:

We’re all watching and waiting for liftoff next week

“I mean, we are going to be obviously watching it very carefully as you all will.” —JP Morgan CFO Marianne Lake (Bank)

You probably have Fed fatigue, but this really is important

“look, I think, if I’m realistic in 2016, the single big thing that is going to drive earnings growth is going to be the rate environment.”–JP Morgan CFO Marianne Lake (Bank)

People are expecting this increase, but will be listening for how the Fed frames future expectations

“from a what happens after the day after, I think a lot of that’s going to again depend upon Fed commentary. So are we going to see a rate increase next week and then what’s the prospect? How do they think – how do we think that they are going to handle rate increases into the future?” —Citigroup CFO John Gerspach (Bank)

Most people assume that the Fed will move slowly

“future increases I would assume will not be too robust, because that would slow the economy too much which I don’t is the Fed’s objective.’ —Blackstone CEO Steve Schwarzman (Asset Management)

US Bank is expecting two more interest rate increases within the next year

“As we think about the interest environment, we are projecting in our plan, a potential for two interest rate hikes next year, and then December 1 of this year; so a total of three if you look out over the course of the next 12 months.” —US Bank CFO Kathy Rogers (Bank)

Banks will benefit from higher interest rates, but Richard Davis wants to be careful what he wishes for

“I’m not one who everyday wakes up wondering and hoping for rates to go up because… while…higher interest rates will help net interest income and margins…the bigger question really is what also comes along with that territory…origination sometimes slows down because the pricing feels higher and consumers themselves haven’t internalized the rising rate.” —Capital One CEO Richard Davis (Bank)

The economy is currently slowing even without higher rates

“the U.S. slowing a little bit, not tragically so and we have interest rates going up in the currency, looks like it will be going up for while and that sort of impacts U.S. economy a bit, It’s harder to export. So those types of companies aren’t doing as well and it also hurts the general stock market, because to the extent that you have earnings being translated from outside the United States that slows down growth rate, because the translation” —Blackstone CEO Steve Schwarzman (Asset Management)

But the consumer is actually fairly healthy

“I think we have a fairly healthy consumer right now. The context of — certainly through the lens of a bank and a huge credit card company I think the striking thing about the consumer is just how responsible the consumer has been, how low credit losses have been, I mean, the losses and the industry losses in credit card are just extraordinary low.” —Capital One CEO Richard Davis (Bank)

They aren’t spending heavily though. Part of it could be a confidence issue.

“one of the things that I think has been a bit surprising is the big reduction in the price of the pump, in other words, it’s almost like a tax cut for consumers, has not yet been spent. Some of it’s been spent, but more of it’s been saved or used to pay down debt in the small business area and I think part of that’s confidence.” —Wells Fargo CEO John Stumpf (Bank)

Another part could be that prosperity remains bifurcated

“The economy overall continues to slowly improve, and customers continue to feel more optimistic, but the bifurcation in the economy remains. Some customers are willing to spend more while others are worried about their job or next paychecks are more focused on saving.” Kroger CEO Rodney McMullen (Grocery)

Lower income consumers have seen cost of living rise faster than wages

“Our consumer is always under pressure. I mean, she lives that way…She is facing a lot of headwinds especially in rents. I mean, rents are up tremendously over the past few years. Our core consumer — our core, core consumer nearly 50% of her take home pay is going to rent today versus just a few short years ago 37%. So you can see the headwind that she’s gotten and quite frankly not a lot of wage growth for her.” —Dollar General CEO Todd Vasos (Retail)

Upper income consumers have it a little easier

“I would say right now I think the domestic, the U.S. economy on the domestic side is very strong, the upper income portion of that remained strong” —Vail Resorts CEO Robert Katz (Ski Resort)

Industries that benefit from low interest rates are showing the most strength

Tech related housing markets have not slowed down at all

“if tech was to slow, I think we have the land in the right locations and we will be fine. I don’t see that happening. We have continued through this week to see tremendous demand and have significant pricing power and I’m very comfortable with how we positioned Northern Cal.” —Toll Brothers CEO Doug Yearly (Homebuilder)

Commercial Real Estate construction is booming

“We believe the construction end market continue to be solid. In particular, non-residential demand continues to be strong in our priority districts. We continue to see cranes across the skyline in most of our major markets” —HD Supply CEO Joe DeAngelo (Industrial Distributor)

If rates rise, home buyers would probably have to purchase smaller homes though

“I think it’s reasonable to assume that as interest rates increase they might select a slightly smaller model than the largest model, which are very popular right now.” —Hovnanian Enterprises CEO Ara Hovananian (Homebuilder)

Higher interest rates would also change the math on Commercial Real Estate deals

“You look at some of the cap rates on real estate, you scratch your head, you look at threes and fours and you don’t know how they make the numbers work.” —Wells Fargo CEO John Stumpf (Bank)

On the other hand, other factors may be more important to asset prices than interest rates

“Well 25 over the last 26 times in history when interest rates went up the value of houses went up…And that’s the way it works. Why? Because you have inflation or you have people making more money with the economy growing and that tends to push up the value of houses.” —Blackstone CEO Steve Schwarzman (Asset Management)


High yield bond spreads have widened significantly. What does that mean for broader credit markets?

“with the high-yield or junk bond market, I think that – clearly those spreads have blown out. I think it was mispriced going in. I mean, I think there is probably a realization that we need to price this properly. I don’t know if that’s a precursor to being concerned about what’s in a loan portfolio.” —Wells Fargo CEO John Stumpf (Bank)

JP Morgan’s CFO says that for now the deterioration is contained to energy

“we don’t see it as being a broader indication of credit deterioration…the stresses that we are experiencing, they are reasonably tightly contained within energy sector.” —JP Morgan CFO Marianne Lake (Bank)

Other banks agreed that energy deterioration is not impacting other parts of their commercial loan portfolios

“we don’t see any real knock-on effects yet from the energy, on other aspects of our C&I book. And certainly from a consumer point of view, right now what we are looking at is very steady credit performance.” —Citigroup CFO John Gerspach (Bank)

“the simple answer is no. We’re really not. Outside of energy, it’s really relatively benign, no significant change.” —US Bank CFO Kathy Rogers (Bank)

However, Toronto Dominion said it is seeing early signs of credit deterioration in consumer loans in energy impacted provinces

“We are beginning to see signs of deterioration in the oil impacted provinces consumer credit portfolios, which again are well within our earlier expectations…in the non-prime auto segment primarily and then in the card segment…in many respects we look at that as an early indicator because that would be the customer that maybe would be more challenged than the typical customer.” —Toronto Dominion CRO Mark Chauvin (Bank)

The housing market in Houston has slowed down too

“In terms of Texas, Houston is slower, no question about it.” —Toll Brothers CEO Doug Yearly (Homebuilder)


Retail sales may have picked back up towards the end of November

“the first couple of weeks of November weren’t terribly exciting and then it got more exciting. And middle of November and late November, it was quite a bit stronger than the first part of November.” —Costco CFO Richard Galanti (Retail)

Times have changed since Christmas 2000 for e-commerce

“everyone went online to shop in 2000 and the selection was probably better, the pricing was probably better, but they couldn’t deliver the product on time, the wrong product showed up, it showed up after Christmas, returns were challenging, the product was broken. And ultimately, the value proposition didn’t deliver. And in 2001, the number of people that shopped online went down.” Twitter CFO Anthony Noto (Social Media)

The organic food industry has gone mainstream

“Throughout the 90s and up until 2014, our industry was a niche. There is no doubt that today we are mainstream.” —UNFI CEO Steve Spinner (Organic Food Distributor)

Even pets are adopting a healthier lifestyle

“If you go down the dog food aisle, the growth in the dog food aisle is in grain-free and natural kind of dog food, so even our pets are jumping onto the bandwagon of leading a healthier lifestyle. Everybody is laughing at me in the room by the way.” —Kroger CFO J. Michael Schlotman (Grocery)

As a result, competition is intensifying and pressuring margins

“we’ve seen an increase in competition across every retail channel and corresponding competition within wholesale distribution and supply chain…our margin certainly isn’t going to go up as we renegotiate these contracts” —UNFI CEO Steve Spinner (Organic Food Distributor)


Costco saw consumer electronics sales turn a corner

“I think if you’d ask me what surprised me in the last month versus the last couple of months, electronic has finally turned and that’s I think a function of people coming in, pricing keeps coming down.” —Costco CFO Richard Galanti (Retail)

But Verizon and AT&T confirmed that phone sales are weak this quarter

“I think last year was a much more dynamic year, plus on top of that you had a new iPhone configuration and new format which drove a lot of volume…you are seeing a less volume year than you did a year ago…but I anticipated that.” —Verizon CFO Fran Shammo (Telecom)

“obviously our upgrade cycles on smartphones is way down this year. People aren’t upgrading like they have in the past…upgrades are not happening as quickly as they were” —AT&T CEO Randall Stephenson (Telecom)

Big enterprises seem to be favoring a hybrid cloud

“what we’re hearing from customers fundamentally is that they want to see the benefits and the economics of public cloud in their private cloud environment. So that would suggest to us that ultimately there is a hybrid cloud solution out there for enterprises” —Cisco CSO Hilton Romanski (Networking Equipment)

The cloud and mobility go hand in hand

“60% of the new applications are actually being built out on the cloud and if you look at that data, the majority of that will be in mobile applications, because mobile is now becoming a really key part of that business process.” —IBM SVP Robert LeBlanc (Enterprise Technology)

In the virtual world, there is still something to be said for getting a team together in an office

“I think that creating connectivity of people and clients in an environment of collaboration is incredibly important and although we live in a virtual world, I fundamentally believe that the people need, to the extent possible, need to be housed in the same location.” Korn-Ferry CEO Gary Burnison (Executive Search)

Everyone wants to learn from Facebook’s culture

“a lot of my conversations today with marketers are to help them understand the Facebook culture and how that could adapt the companies that have been around for 100 plus years. That’s the first thing that’s on every company — every big company’s mind” —Facebook VP Carolyn Everson (Social Media)


Healthcare spending growth may slow next year as comps get difficult

“U.S. has been stronger than I can remember for a long time and that is not only the medtech sort of companies but also hospitals. Now as we going to sort of calendar year ’16, there will be some anniversarying that is happening and also some of the hospitals have reported slightly sort of lower growth rates…I do not know to what extent the procedure growth will continue at the same rate of growth. I do not think it will slowdown, per se, but the growth rate might well slowdown.” —Medtronic CEO Omar Ishrak (Medical Device)

Materials, Industrials, Energy:

Oil producers have been very effective at continuing to lower the cost of production

“the break-even perhaps used to be $90 to $100 probably. The marginal cost of supply was $90 to $100, now it’s probably $75 to $80. For EOG we would be tickled to death for $60, $65 price. I think we’d be able to generate really strong rate of returns and grow the company at very healthy level at $60 or $65 price environment.” —EOG EVP Billy Helms (Oil E&P)

As a result, oil drilling activity has not slowed down as much as expected

“North America does look like it’s going to be marginally better than what we said in the third quarter call” —Halliburton CFO Christian Garcia (Oil Service)

Capital budgets will fall again next year though

“We’re announcing a 2016 capital budget of $7.7 billion that’s $2.5 billion lower than 2015 capital guidance and more than $9 billion lower versus 2014.” —ConocoPhillips’ CEO Ryan Lance (Oil & Gas)

It’s tough to say where prices will settle

“I had a funny conversation with…the head of one of the largest companies in the world in the energy business. I asked him what he thought about energy prices, he said “well we plan for somewhere between $20 and $120…I know it’s going to be some more in that range” and I said well that’s very precise.” —Blackstone CEO Steve Schwarzman (Asset Management)

It’s still not easy to find great acquisition targets

“You’re right we started off the year thinking okay in this down cycle we might seen an opportunity for a corporate acquisition. And we’re not really used to the company to doing that, but we’re hoping at the opportunities. And we looked at the lot of different things, but we never really saw anything that would compete with our portfolio here that we’ve shown.” —EOG EVP Billy Helms (Oil E&P)

Miscellaneous Nuggets of Wisdom:

Find good partners

“We go in there saying we really like this business, but we want to be makes sure we do it on the right terms; that is starting with looking for partners…choosing those that are motivated for the right reason…I have found that that motivation drives just about everything about how partnership works and really affects the attractiveness. We are very focused on going to the right players who really and to work with them to build deep customer relationships.” —Capital One CEO Richard Fairbank (Bank)

Play to win

“I didn’t play for any attention. I played for the hardware. I wanted to know that I beat everyone in this field, and I wanted them to know that they got their butt kicked.” —Tiger Woods TIME magazine interview

Full transcripts can be found at

June 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

The CEO of Blackstone, Steve Schwarzman wrote an editorial in the Wall Street Journal today warning about the state of liquidity in fixed income markets. In the editorial he wrote that regulation has created significant instability for the financial system.

This marks the third major financial sector CEO to make this warning and we should all be paying attention to what they’re saying.

In today’s editorial Schwarzman wrote:

“The Volcker Rule… bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt”

This echoes sentiment expressed by Jamie Dimon, CEO of JP Morgan, in his letter to shareholders earlier this year:

“market depth is far lower than it was, and we believe that is a precursor of liquidity…The likely explanation for the lower depth in almost all bond markets is that inventories of market-makers’ positions are dramatically lower than in the past…Inventories are lower – not because of one new rule but because of the multiple new rules that affect market-making, including far higher capital and liquidity requirements and the pending implementation of the Volcker Rule.”

And Larry Fink, the CEO of Blackrock, has been saying the same thing since October:

“we are worried about the liquidity in the fixed income market especially in the corporate bond area…importantly this is the big role that the investment bankers and Wall Street played in terms of providing balance sheet…and that balance sheet has been reduced significantly. And so it does at times present liquidity issues.”

The most important thing about these warnings is that these are three of the best CEOs in the financial sector. Jamie Dimon, Larry Fink and Steve Schwarzman are each second to none within their respective industries. Combined they represent almost $7 trillion in financial assets, which is roughly 10% of all financial assets in the United States. When these three are speaking it’s worth listening.

Here’s an explanation of what they’re talking about:

Unlike equity markets that are traded on exchange, fixed income markets are traded “over the counter.” This means that when you buy or sell a bond an investment bank like JP Morgan or Goldman Sachs facilitates the trade. If you are a seller of a bond, Goldman will buy that bond from you and sell it to another of its clients at a slight mark-up.

Before the financial crisis, investment banks could “use their balance sheet” to purchase your bond whether or not an immediate buyer could be found. They would “make a market” and hold the bond in their own inventory.

This inventory was a primary source of leverage on bank balance sheets before the financial crisis. In fact, part of the reason that asset prices were crushed in 2008 was that banks were liquidating this inventory. Think of it like a retailer closing down a location. The entire store went 50% off.

After 2008, regulation restricted banks from rebuilding inventory to prior levels. This made the banks more stable, but now if you want to sell a bond the investment banks need to find a willing buyer on the other side of the trade. It’s much harder for them to purchase it for their own inventory.

In a normal market this isn’t that big of a concern because there are plenty of buyers for every seller. But in a crisis it becomes harder to find buyers. As Jamie Dimon warned, liquidity already dries up in a crisis and without liquidity, prices can fall precipitously:

“Liquidity can be even more important in a stressed time because investors need to sell quickly, and without liquidity, prices can gap, fear can grow and illiquidity can quickly spread – even in supposedly the most liquid markets.”

The other highly disconcerting thing about these warnings is that they sound eerily familiar to a warning made by the head of the New York Stock Exchange shortly before the crash of 1937. In the 1936 NYSE annual report, Charles Gay warned that New-Deal regulation was impacting liquidity:

“I am fearful that, in an effort to cure what might be termed sporadic evils, undue restraints are being placed upon normal, proper action, thus creating abnormal market conditions. Evidence accumulates that the quality of the market has been seriously affected. With much concern I note the continuance of narrow, illiquid markets in which wide spreads between bid and asked quotations prevail and in which comparatively small volumes of buying or selling create undue fluctuations in prices. Almost daily, situations are called to my attention wherein it is impossible to buy or sell reasonable amounts of stock at reasonable prices. Orders which, a few years ago, could have been executed within a few minutes or a few hours now often require days and sometimes weeks, with resulting increased risk to the owner.”

Over the next seven months the Dow fell by 47%. A lack of liquidity was heavily cited as a reason for the intensity of the decline.

History doesn’t repeat, but it does rhyme. Especially as fixed income markets have started to show weakness recently, these sorts of warnings should be heeded.

This is one of the many reasons that we hold no fixed income securities in our portfolios today. Fixed income markets remain one of the most dangerous places for an investor. Equity markets are relatively less exposed to these issues, but stock prices have increasingly been tied to interest rates. If there is a convulsion in fixed income markets, equity markets are unlikely to be unscathed.

If I held bonds today and could sell them in a tax efficient manner, I would take the opportunity to do so. Cash holds significantly more value because it gives the investor the ability to purchase assets at bargain levels if a liquidity panic does come to pass. Furthermore, interest rates and inflation are so low that there is little penalty for holding cash. Better values will present themselves. All it takes is a little patience.

Scott Krisiloff, CFA

Prices Have Diverged From Earnings

92% of S&P 500 companies have now reported Q1 earnings.  According to Standard & Poors GAAP earnings for the last 12 months are just $99.18.

That is down 6.4% from peak earnings, which were posted after the third quarter of 2014.  That is also down 1% from the earnings number posted all the way back at the end of 2013, which means that earnings have not grown since January of 2014.

Despite no earnings growth since January of 2014, the S&P 500 is up 15% since then.  It has moved from an already high multiple of 18.5x to an even higher multiple of 21.5x.

A few notes:

–S&P’s numbers are “per share” which means that they factor in the effect of buybacks.  So this divergence can’t be explained by corporate actions.

–It’s true that earnings have been impacted by oil prices and exchange rates.  But if you own the S&P 500 you own oil fields and companies with foreign operations, so the earnings power of your property has been impaired by the environment.

–TTM earnings are expected to stay at the $99 level through 3Q15 and then jump to end the year at $106.54.  Operating earnings are expected to stay at the $111 level and jump to $116 at year end.  This implies 31% and 18% earnings growth in Q4 for GAAP and operating earnings respectively.  When people talk about PE multiples compared to forward earnings they are factoring in this growth.

–That growth is expected to continue in 2016.  EPS is projected to be up 15-17% in 2016, reaching $133 per share.  At this point in 2014, analysts expected 2015 earnings to be $137.  So take analyst projections with a grain of salt.


Prices have diverged from earnings

May 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

A few weeks ago, Warren Buffett said in a television interview that equity prices still look cheap as long as interest rates remain low. In the same interview though, he mentioned that if he could short 20 and 30 year bonds (in effect betting that interest rates would rise) he would do that. What Buffett was effectively capturing with his statement is that stocks are cheap relative to bonds, but only because bond prices are so high that they verge on irrationality.

There is no greater example of this irrationality than in Europe where last month 10 year bonds were trading at negative interest rates. This should not be possible. A rational person would never loan someone $100 with a promise to receive $99 in return. Instead they would just keep the $100.

Negative interest rates can only exist because central banks around the world have pushed them there. Central banks have the power of government behind them, so they have the power to hold rates wherever they want.

For that reason, I wouldn’t bet on rates to rise until central banks allow them to. But just because central banks are keeping rates low doesn’t mean that stock prices should be measured against those low levels. Two wrongs don’t make a right, and just because bond prices are irrational doesn’t mean that equity prices should be too.

In the history of the United States, we’ve been at low government-mandated rates before, but didn’t fall into the trap of inflating equity prices along with them. The Federal Reserve’s discount rate was below 1.5% from 1934 through 1950. However during that whole period the S&P 500 averaged a multiple of just 12.8x. Even after the war, equity multiples remained low despite negative real interest rates. Between 1945-1950, equity multiples averaged just 11x earnings while the 10 year treasury yield remained below 3%.

Clearly history demonstrates that it’s possible to separate stock market valuations from bond markets. It’s a choice to peg equity prices to fixed income prices, and investors could just as easily choose to ignore markets that are clearly not dictated by natural market forces. But, practically speaking, in today’s world it seems unlikely that equity prices will decouple from bond prices. If bond prices remain irrationally high, it’s probable that equities will converge to those prices no matter how irrational that may be.

Luckily it’s not likely that bond prices will remain at these levels for the long term, because the Fed has no intention to keep rates here forever. In fact, the exact opposite is happening. Over the last 17 months, the Fed has systematically been removing the stimulus that has kept bond prices so high. At first it did this by tapering QE, then by hinting at a rate increase, and finally at some point in the next year, it is likely that the Fed will actually raise short term rates.

Benjamin Graham, Warren Buffett’s mentor, once said that in the short run the market is a voting machine, but in the long run it is a weighing machine. For the last six years, Fed policy has acted like a 50 lb. dumbbell on our market’s bathroom scale. It has increased the weight (prices) that scale displays at a given level of mass (profits). The Fed is now slowly lifting its weight off of that scale, and soon profits will be weighed on their own merits.

It’s difficult to say for sure what the “weight” of the market will be without the Fed’s dumbbell, but we do know that GAAP earnings peaked last year at $105. Since 1965 the average multiple of the S&P 500 on peak earnings is 15.5x. If the multiple returned to that level on today’s peak earnings, the S&P 500 would trade for 1,627, a 23% decline from current price levels. In bear markets, prices usually fall well below average though, which means that a decline could be much larger than just 23%.

Scott Krisiloff, CFA

Thoughts on GE Capital’s Capital Disposition

We’re not GE shareholders at Avondale, but it is a company that I have followed over the years.  As a former bank analyst, GECC is a division that I have always made special note of during that time.  The company’s decision last week to substantially wind down the operations of its capital division is a big one.

I just went through the conference call that the company held last week and even though many people seem to like the deal, I’m having trouble seeing how the numbers work out to generate value for shareholders.

Here are some notes:

1) This is a big hole to fill: GE Capital’s operating earnings were $7 Billion in 2014, or 42% of the company’s total.  The company will be retaining part of GECC after these dispositions and has said that it expects the remaining piece of GECC to earn about $1.5 Billion run rate.  That means that the company is walking away from $5.5 Billion in earnings.

2) In exchange for giving up those $5.5 Billion in earnings, it looks like the company will generate about $55 B in cash.  (Note, the company is claiming $90 B in capital return, but $35 B of that appears to be dividends from the core business).  Management expects to use this cash primarily to buy back shares.  The important number to focus on is the pro-forma share count after buybacks, which management expects to be 8-8.5 B in 2018, down 15-20% from current levels.

3)  Based on the current earnings of the industrial business and the leftover GECC earnings power, the “new” GE would earn ~$11 B today on a pro-forma basis.  Even on a share count of 8 B, that’s only $1.38 in operating EPS, compared to $1.65 in 2014.  That means the deal is not accretive to EPS and that instead of trading for 16.7x trailing operating earnings, GE is now trading for 20x pro forma earnings.

4) GE’s management says that the company will still earn the same amount per share in 2018 as it would have otherwise, but with better quality of earnings.  The company is giving up 1/3 of its earnings power and only buying back 15-20% of its share count, so if the company is still going achieve this, the industrial core will have to grow faster than it otherwise would have.  It’s not clear how this transaction helps achieve that.

5) The reason that management gave for the disposition is that “we just did not see an attractive proposition for getting return on capital that made sense for the Company or make sense for shareholders.”  That argument has big implications for the way that other financial services businesses are valued if you believe it.

6) However, management may have valued GECC at less than the market did.  On the call management said that they saw GECC as worth $75 billion.  That’s 10-11x earnings and consistent with where other big financial institutions like BAC and JPM are trading.  However, the difference between JPM and GE is that GE was probably getting a market multiple for its capital division.  GE’s multiple on as reported earnings is currently ~18x.  Considering 42% of those earnings come from the capital unit, if that unit was only worth 10x earnings, it means that the industrial core was valued at 22x-23x.  That’s about where MMM trades, so maybe that’s not so crazy on second thought…

7) Do financial services companies only deserve to trade for 10x earnings though?  GE said that it couldn’t earn its cost of capital in financial services with an ROE of 8.6%, but what’s the cost of capital in a 1.9% interest rate environment?  When everything else is selling for 20x earnings, an 8.6% ROE doesn’t look so bad.

8) Financial companies in general appear to be priced as if there is no long term franchise value above what’s on their books.  This seems far from accurate.  GE itself talked about the enviable market positions that it has in some of its lending businesses.  From the call it sounds like the company will be focused on selling portfolio assets, not operating assets.  If that’s the case then shareholders should consider that GE has destroyed serious value.  What will become of the teams that achieved leading positions in middle market lending, equipment financing and the fleet services business?  If they are simply laid off and competitors like CIT get to pick up the pieces then GE shareholders have been done a major disservice.

9) Could GE’s decision actually be a contrarian sign that the worst is over for large financial services companies? GE doesn’t have a pristine record as a capital allocator under Jeff Immelt.  In 2007 the management team steered the company hard towards clean energy (especially windmills) and emerging markets infrastructure investments.  Both were hot ideas at the time which have since lost luster.  Since 2011, the company has spent billions of dollars on acquisitions in another hot sector, oil services, including a $3 B purchase in April of 2013 just as the price of oil was peaking.  So, just because GE says that returns on capital in financial services wont recover doesn’t necessarily mean that they’re right.  In fact, recently the company has had a track record of being wrong.

April 2015 Investor Letter

Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

With a quarter of the year now gone, the stock market is essentially still flat for 2015. Throughout the year, stocks have seesawed back and forth trying to find their bearings. Although a few months of sideways movement is common behavior for markets, history teaches us that prices don’t typically remain in a sideways range for much longer than that. After a few months of consolidation, prices will usually break out in one direction or the other. The question of course is which way will they break?

Fundamentals continue to suggest to me that the break should be lower, not higher. Valuations are still extremely high, earnings are likely to fall this year, and monetary policy is getting incrementally tighter. Still, as I talked about last month, there would certainly be precedent for higher prices, it would just mean that markets have reached into undeniable bubble territory.

While markets will resolve these issues over the next several months, I think the most important change that I noticed in the first quarter of 2015 isn’t something that markets are focused on at all, but has the potential to have a massive influence for many years to come. In 2015, it seems that the Baby Boomer retirement wave is finally hitting.

In my own wealth management practice, I am seeing signs that retirement is starting to “cross the chasm” to mass market adoption. Within the last quarter, several of my clients have let me know that they are retiring this year. These are quintessential Baby Boomers, born between 1945 and 1955. They have been working for 40 years plus and are simply ready to move on to other things. I couldn’t be happier for these individuals. Each one of them deserves the opportunity to kick back and relax after decades of contribution to our economy.

Yet, as an asset manager, the decision to retire is bitter-sweet for me, because I know that clients who are retiring go from being asset accumulators to asset distributors. Put simply, rather than growing the balance of their accounts, these clients will now likely be drawing them down, or at best holding them flat. These clients will now be unlocking their savings for the reason that it was accumulated in the first place: to finance their retirement.

This trend, which I am observing on a micro level in my business, is likely to have a profound effect on capital markets. These clients and millions of Baby Boomers like them are the owners of America’s productive assets. The owners of those assets are undergoing a major shift in investment objective. They are going from a growth mentality to an income mentality.

For the last several decades, Corporate America has been managing American companies to a mandate which is now changing. Companies have been asked to produce growth at any cost, because higher stock prices indicated to Boomers that their retirement portfolios were growing, which made for happy shareholders.

Early on, companies generated growth by retaining earnings and reinvesting capital, and as organic growth has slowed, lately they have engineered growth by buying back shares. Even though many times these decisions were made at sub-optimal levels, owners typically didn’t mind because they were looking for capital appreciation. But now owners will ask to realize returns, and owners can only do that in two ways: either by receiving dividends or selling shares.

In an ideal environment, Boomers would be able to generate returns without having to sell assets. Income received from dividends and bond coupons would be enough. However, this isn’t a normal environment. Today very few if any assets are producing enough income to cover necessary expenses. With the dividend yield of the S&P 500 ETF at just 1.9% and the 10 year treasury yield at a similar level, back of the envelope math suggests that a Boomer would need a portfolio of $2.6 million to generate $50,000 per year in current income before taxes.

It’s my sense that most boomers and their financial advisors have probably not underwritten their retirement with the assumption of a 1.9% return on their investment portfolios though. This means that in order to generate the requisite income, Boomers will have to become sellers of assets in order to produce yield.

The question is: at what price will they be able to make these sales? Current owners, who are aging, will be selling to a younger generation. This actually represents a natural transfer of assets from one generation to the next. However, for most of the younger generation, incomes cannot support purchasing those assets at current price levels.

Real estate is perhaps the most tangible example of this phenomenon. Talk to a group of Millennials about buying real estate in Los Angeles, and more often than not you’ll hear “I don’t know how I could ever afford to buy a house here.” Securities markets are just as expensive, but the problem is masked by the fact that the buyer is only purchasing shares not whole businesses. Incomes cannot justify today’s market prices, and the result is that younger generations are purchasing much smaller percentages of companies than they otherwise would be able to. The younger generation is trying to build its ownership of assets, but it can’t in the current environment.

As a result, when Baby Boomers become incremental sellers of their portfolios, they will have to do it at prices that younger generations can afford. In other words, this is one more reason why markets are probably headed lower.

So what does all this mean for our investment portfolios?

It’s important to remember that while forces like these are real, they evolve at such a glacial pace that it’s tough to apply them along any meaningful timeframe. To be clear, we’re not making any near term investment decisions based on the fact that Baby Boomers are retiring.

Still, this information does have an impact on our assumptions for trends in reasonable valuation. I would be much more prone to believe that the PE multiple of the S&P 500 could reach 30x again if Baby Boomers were at a different stage of their lives. However, since they are not, I do expect average multiples to decline, not rise, over the coming decades. In my opinion, that makes it even more important for us to continue to hold cash. Valuations will fluctuate widely around their long term averages and the averages are probably trending lower.

If you’re a Baby Boomer considering or approaching retirement, it’s important to keep in mind that today’s asset prices are inflated. The economic value of a portfolio at today’s levels can not necessarily be taken at face value. Stress your assumptions about the rate of return that your portfolio will generate. And if you have a strong stomach you may want to assume that the true value of your invested portfolio is about 30-35% lower than current levels. From those prices the standard 5-8% growth assumptions are more reasonable. The other alternative, which is the path that we are taking, is to utilize the tax advantages of retirement accounts to sell at these high levels.

One of my mentors in this business once told me that a great advantage in his life was being born in 1943. That made him an early Baby Boomer who was always just one step ahead of his peers. Anything he bought, he got there just before a wave of buying came along to force up the price.

Today we find ourselves in that situation reversed. As Baby Boomers age all the assets that they have accumulated throughout their lives are now being distributed. It will behoove Baby Boomers to be selling earlier than their peers so that they can realize peak prices and preserve capital to reinvest at more favorable ones.

Conversely, younger generations should continue to save, but remain patient holding cash. I promise that eventually we will get a chance to purchase the productive assets of society at prices which are reasonable relative to our incomes. The reins of the American productive machine are now being transferred from one generation to the next. The transition will not be totally seamless, but for those who plan ahead, it can be extremely profitable–for this generation and the next.

Scott Krisiloff, CFA

Comps are About to Get Tougher

Last week in Ford’s monthly sales call the automaker noted that auto sales would likely be flat for the industry in March versus the year before.  They noted that this was partially due to a difficult comparison versus the prior year.  Here’s the exact quote from Ford’s call:

“a year ago March, in February we were in the deep freeze…March was kind of a breakout month a year ago…I think the comparison is a little bit difficult to March of last year because of what happened with the weather and the comparison.”

Recall that last year there was a pretty harsh winter in January and February which depressed economic data.  In March the weather subsided, which led to a big uptick in economic activity that month.  That big uptick made it difficult to eclipse that mark in March of 2015.

The spring rebound from last year may have greater implications for reported economic growth beyond just March though.  As demonstrated by retail sales in the chart below, comparisons may continue to be difficult for the remainder of 2015.

March and April provided big boosts to retail sales but then growth started to flatten into year end.  Retail sales have actually declined month over month since October of last year.  As a result, in February of 2015 retail sales were just a little above where they were in April of last year and below where they were in May.  That means that if retail sales remain here for the next few months, they will begin to register year over year declines a few months from now.

Other economic data may be picking up similar trends, which means that rather than recovery in the next couple of quarters, economic data may continue to get worse.

Comps Tougher

S&P 500 Longest Quarterly Win Streaks

I’ve heard a lot of people mention that the S&P 500 has now risen for nine straight quarters, but I hadn’t seen a comparison yet of how that compares to other streaks, so I figured that I would put the data together.  Below is a list of the longest quarterly win streaks in S&P composite history (the S&P 500 starts in 1957) going back to 1900.

There are five other times that quarterly win streaks have lasted longer than this one.  The median decline in the quarter that the streak is broken is just 2.6%.  The median change over the next twelve months is actually positive 2.4%.  The end of the streak signaled the end of a bull market in two of the five instances (1929 and 1956), although the 1956 bear market just barely qualifies as a bear.

As far as the streak goes, this one has ranked near the bottom in terms of performance (but if it goes on for another 5 quarters that may change).  We’ve only risen 45% in the last 9 quarters compared to triple digit percentage gains in three of the five other streaks.

This nine quarter run is pretty rare.  In 1946 and 1951 there were two 7 quarter streaks, but there aren’t any streaks that ended at eight quarters.

S&P 500 longest quarterly win streaks

A Rare Y/Y Decline for CPI

Last week the BLS reported that headline CPI fell from one year ago.  This is primarily because energy prices have fallen.  Core CPI (which excludes food and energy) has not registered the same slowdown.

Even though food and energy prices are volatile, it’s rare that a decline in either of those categories will pull CPI changes into negative territory.  This is only the 4th period since World War II that consumer prices have fallen vs. where they were a year earlier.

The other times were: the financial crisis (2009), the aftermath of World War II (1949), and a period in 1955–I’m not sure what happened there.

Before WWII, from 1914-1947, CPI only decreased in four additional periods:  early WWI (1915), the aftermath of WWI (1921), the Depression (1930-1933) and Depression II (1938).

Since it began measurement in 1958, core CPI has never fallen y/y.  It did increase at rates below today’s levels between 1960-1966 though.

Negative CPI

Can S&P Earnings Rise if Sales Fall?

According to Factset, analysts now expect S&P 500 sales per share to fall by 1% for the full year 2015.  However, the same estimates have earnings rising by 2% in the same period.

If revenue is going to be lower this year, it’s not likely that profits will rise.  In order for that to happen, businesses will have to find a way to cut costs faster than revenue is falling and expand profit margins to higher highs.  That will be a difficult task considering that usually margins leverage off of fixed costs, so profits expand faster than revenue when revenue is rising, but also contract faster than revenue when revenue is falling.

If revenue is going to contract this year, it’s more likely than not that earnings will too, which means that earnings estimates for 2015 probably still need to go lower.

So when people say that the S&P 500 is trading for 17x forward earnings, that’s a bit of an illusion.  At 2100 it’s actually trading at 20.5x trailing as reported earnings and 18.6x trailing operating earnings (S&P has 2014 operating earnings at only $112.9).  If earnings don’t grow this year, then the forward multiple is even higher than the trailing one.

Sales Fall Earnings Rise