OF DEMOGRAPHICS AND PRODUCTIVITY
Following up on yesterday’s post dealing with demographics and productivity in which I concluded:
All this to say that we should all modify our mindset away from expectations for a return of rapid growth rates and understand that the economy is set to grow very slowly for many years.
Yesterday, David Rosenberg wrote this following the release of poor U.S. productivity stats:
We have basically a half-point trend in productivity and a half-point trend in the annual growth of the working-age population (…), so if potential supply-side growth is 1%, maybe we should start adjusting our expectations, in Japan-like fashion (okay, maybe more like Europe) to the possibility that 2% GDP growth in today’s sclerotic economy is a virtual boom!
Rosy went on to question why would businesses continue to hire more folks in such an environment and concur with me that we may well be in the early stage of a margin squeeze:
So compensation per hour rose at a 3% annual rate in Q1 while the implicit price deflator slowed to a mere 0.5% annualized pace (look at the pricing pattern over the past four quarters: 2.3%, 1.0%, 0.9%, 0.5%).
That is what is otherwise known as a margin squeeze.
Finally, Rosenberg commented on the negative trade flows to conclude
But net/net, the incoming data flow is not exactly deserving a market multiple two-to-three points above the norm, no matter the level of interest rates.
So, manage your risk accordingly. To help us all, Credit Suisse offers this analysis:
(…) Investor expectations about future revenue growth and profitability both play a key role in driving multiples. Investors obviously prefer high levels of both. But if there’s only one to be had, which combination do investors value more highly? Superior growth and low profitability? Or lower growth and high profitability? Credit Suisse recently analyzed the performance and multiples of companies with market capitalizations of more than $1 billion (excluding financial firms and utilities) between 2004 and 2015, to find out.
Not surprisingly, the bank found that companies with above-median projected growth in revenue and above-median projected profitability traded at an 11.5x EV/EBITDA multiple, compared to just 7.5x for firms with below-median estimates for future revenue growth and profitability. (For reference, the median projected revenue growth was 5.4 percent and the median profitability was 6.5 percent cash flow return on investment.)
But back to the question of revenue growth versus profitability. It turns out that firms with below-median forecasted growth but above-median projected profitability earned higher EV/EBITDA multiples (10.2x) than faster-growing but less profitable companies (8.7x). Furthermore, increases in expected profitability had more of an effect on valuations than did an increase in expected sales. Regardless of whether a company is expected to grow above or below the market median, if it manages to improve profitability above median levels, the effect is dramatic—an additional 2.7 times enterprise value relative to the company’s forward cash flows. That was more than twice the effect that improving revenue growth—an additional 1.2 times EV/EBITDA—awarded to those companies that managed to climb into above-median revenue growth territory. Those that were able to vault over the median in both categories saw multiples rise by 4x EV/EBITDA. In short growth matters more when you combined it with superior return on capital.
Source: Credit Suisse HOLT Corporate Advisory
It’s interesting to note that the current preference for profitability over growth is a relatively recent phenomenon. Between 2004 and 2007, companies with above-average revenue growth expectations traded at higher valuations than those with high profit expectations. During the financial crisis, there was no clear pattern to investor preferences, but high-profitability companies began to deliver higher premiums in 2012.
One possible rationale for the shift: Over the past decade, it’s been easier to keep returns on capital up than to produce drastic increases in sales. Fewer than one-third (29 percent) of companies that produced above-average revenue growth between 2004 and 2009 did the same between 2010 and 2015, while nearly two-thirds (64 percent) of companies that were highly profitable in the first five-year period remained so in the second.
Investors, in other words, can be fickle. So how should that affect executive decision-making? For executives making resource allocation decisions, it’s clear that both profitability and growth matter. But understanding exactly what drives investor sentiment about a company is important not only in choosing between competing strategies — those promising faster growth or superior profitability (or, in an ideal world, both) — but also what to buy and how to buy it. Knowing how expectations of future growth and profitability drive valuations can help companies decide on the right price to pay for potential targets as well as secondary decisions, such as whether equity or cash purchases make more sense. In other words, multiples matter for more than just bragging rights.
Keep in mind that companies that have achieved high margins thanks to ample labor availability and low wages will find it tougher from now on. In this slow growth/rising wages environment, good and rising dividends and above average earnings visibility will attract higher valuations.
CHINA’S DEBT PROBLEM
Goldman Sachs sets the stage (via BI):
The combination of rising indebtedness with slower growth can be lethal.
Now read this:
CLSA Sees China Bad-Loan Epidemic With $1 Trillion of Losses
Chinese banks’ bad loans are at least nine times bigger than official numbers indicate, an “epidemic” that points to potential losses of more than $1 trillion, according to an assessment by brokerage CLSA Ltd.
Nonperforming loans stood at 15 percent to 19 percent of outstanding credit last year, Francis Cheung, the firm’s head of China and Hong Kong strategy, said in Hong Kong on Friday. That compares with the official 1.67 percent.
Potential losses could range from 6.9 trillion yuan ($1.1 trillion) to 9.1 trillion yuan, according to a report by the brokerage. The estimates are based on public data on listed companies’ debt-servicing abilities and make assumptions about potential recovery rates for bad loans.
Cheung’s assessment adds to warnings from hedge-fund manager Kyle Bass, Autonomous Research analyst Charlene Chu and the International Monetary Fund on Chi na’s likely levels of troubled credit. The IMF said last month that the nation may have $1.3 trillion of risky loans, with potential losses equivalent to 7 percent of gross domestic product.(…)
Byron Wien: What Investors Need to Know About China
(…) I have just returned from a trip to Singapore, Hong Kong, Beijing, Shanghai and Tokyo, meeting with sovereign wealth funds, other clients, policy officials and business people. While everyone is aware of the slowdown in China, very few expect a hard landing caused by a real estate bubble, a banking collapse related to non-performing loans or other factors. (…)
Because the banking system is integrated into the People’s Bank of China, the assumption is that there won’t be a banking meltdown, but that may not be right. (…)
Banks also need to become more profit-oriented. One of the reasons there are so many non-performing loans on their books is that the managers know that big or small, they can’t fail: the government will bail them out. (…)
The key government objective is to maintain stability, not profitability. and the Chinese seem to accept that. One official told me that Xi is highly focused on the need to retain the approval of the people. Civil unrest is to be avoided at almost any cost. (…)
(Hint to access the Barron’s article: copy/paste the headline in your browser and click on it. Google will then display related links. Click on the link to Barron’s. It generally works fine.)
OIL
Americas, Asia do what OPEC wouldn’t: cut oil production Wildfires in Canada. Instability in Venezuela. Stalling U.S. frackers. Drops in oil output are happening so fast that it looks as if the Americas alone could resolve global oversupply.
(…) Output from the Americas dropped over 1.5 million bpd last quarter, while producers in Asia and Australia cut some 250,000 bpd, eating away large chunks of the world’s oversupply, government, industry and consultancy data shows. (…)
A raging wildfire in Fort McMurray, at the heart of Canada’s oil sands region, has forced more than 690,000 bpd out of production, according to Reuters estimates, with more disruptions possible. (…)
U.S. output, down by 410,000 bpd this year and 800,000 bpd since mid-2015, is expected to slide another 800,000 bpd in the next five months, according to the Energy Information Administration.
Latin America’s crude oil production, suffering from under-investment, fell 4.6 percent in the first quarter to 9.13 million bpd, a loss of 441,000 bpd from the same period a year ago, according to data from individual countries and OPEC.
The largest decline was in Venezuela, which lost 188,000 bpd in the first quarter as President Nicolas Maduro’s government wrestles a deep economic crisis.
Production is also on the wane across Asia Pacific.
China, the region’s biggest producer and consumer of oil, is expected to see a 6 percent drop in crude output in 2016 due to ageing fields and poor economics, Standard Chartered bank said. (…)
CEBM says China’s domestic oil output declined 4% YoY in March and 2% in Q1’16.
EARNINGS WATCH
The Q1’16 earnings season is almost over with essentially traditional retailers remaining to report over the next 2 weeks. RBC says that their earnings are projected to decline -1.5%. Early reporters have beaten by 2.3%, half the pace of other S&P 500 companies.
- 431 companies (87.9% of the S&P 500’s market cap) have reported. Earnings are beating by 4.5% while revenues have missed by -0.4%.
- Expectations are for a decline in revenue, earnings, and EPS of -1.9%, -7.0%, and -4.8%.
- EPS is on pace for -4.3%, assuming the current beat rate for the remainder of the season. This would be +0.8% excluding Energy.
US stock funds suffer $11bn of outflows Redemptions since the beginning of the year top $60bn
(…) Portfolios invested in US equities recorded $11.2bn of outflows in the week to May 4, accelerating redemptions from the asset class since January to more than $60bn, according to Lipper. (…)
Investors also continued to pull money out of equity funds for Japan, the UK and Europe, according to the latest weekly EPFR data.
European stock funds extended the longest streak of redemptions in nearly six years, with investors withdrawing $4bn from German equity funds since February.
UK stock funds suffered the biggest weekly redemption since mid-December. Japan extended its current outflow streak to six straight weeks, the longest since the third quarter of 2014. (…)
US investors have turned to money market funds — often seen as a proxy for cash — adding $6.5bn in the past week. Funds invested in US Treasuries recorded $44m in new investments. (…)